We daily receive calls from investors curious about 1031 Exchanges and Delaware Statutory Trusts (DSTs). In this blog, we’ll talk about the necessary requirements to complete a fully tax-deferred 1031 exchange.
I plan to complete a 1031 exchange by selling an investment property and buying a new property to defer the capital gains taxes. I have more cash to reinvest, and I know there are strict requirements for the value of my new property. What is equivalent or higher?
‘Equal or greater’ is the amount required to obtain a replacement property in a 1031 exchange. To completely defer the capital gains taxes, the replacement property purchase cost must be equal to or higher than the value of your exchange funds. The value of exchange funds typically represents the debt, the equity, and profits earned on the sale of a relinquished property.
Most people assume ‘equal or greater’ means that the purchase amount of the replacement property must be equal to or higher than the sale price of the relinquished property. This, however, is incorrect. Transaction fees from the sale of a property will decrease the value of the exchange funds, so the purchase value of the replacement property will not have to evenly match the sales price of the relinquished property. Likewise, transaction fees needed for the purchase of the replacement property can be given using exchange funds, also lowering the intrinsic value of the purchase price.
Let’s take an example, if you sold a property for $550,000, paying $30,000 as transaction fees. If you had $225,000 equity in the property and you have $275,000 as of the remaining debt on the property, you would have $20,000 in profits. The value of exchange funds is the sum of these amounts, or roughly $520,000. If you’re assuming about $20,000 in acquisition fees, you should look for a property that is around $500,000 to qualify for your exchange as an equally valued replacement property. Any property valued higher than this that would require a contribution of personal funds would also be qualified for your exchange, qualifying as greater valued replacement property.
Assuring the replacement property value is equal to or greater than the value of your exchange funds will help you to prevent incurring taxable boot when you close your exchange. Cash boot generally occurs when all of the funds of exchange are not used for qualifying acquisition expenses.
Expenses that can be met using exchange funds include legal fees, sales inspection fees, commissions, escrow fees, document fees, title insurance fees, notary fees, recording fees, and others. Expenses that cannot be paid using exchange fees include mortgage points, utility costs, property insurance, mortgage insurance, property repairs or termite work, HOA dues, and others.
Many investors have discovered that DSTs help to simplify the exchange process by reducing the risk of excess exchange funds. Because obtaining beneficial interests in a DST property does not need additional acquisition fees, exchange investors do not have to estimate a portion of their exchange funds for use on acquisition fees. Instead, once exchange funds are estimated, the total can be used in one transaction to buy interests in the DST.
Bottom line: In a 1031 exchange, you are always entitled to contribute additional funds to obtain a property valued higher than the value of your exchange funds. However, you must obtain a property with an acquisition value at least equivalent to that of your exchange funds to avoid capital gains taxes.