The 1031 Exchange Equation: “Balancing the 1031 Exchange”

Realized Gain vs. Recognized Gain

Whenever property is sold, it is important to make the distinction between realized gain and recognized gain. Realized gain is defined as the net sale price minus the adjusted tax basis. Recognized gain is the taxable portion of the realized gain. The common objective in a tax deferred exchange is disposing of a property containing significant realized gain and acquiring a “like-kind” replacement property so there is no recognized gain. In order to defer all capital gain taxes, an Exchanger must “balance the exchange” by acquiring replacement property that is the same or greater value as the relinquished property, reinvest all net equity and replace any debt on the relinquished property with debt on the replacement property (although a reduction in debt can be offset with additional cash.)

The 1031 Exchange Equation

The Exchanger can quickly calculate whether there will be recognized gain based on the following principals:

Taxable “boot” is defined as non like-kind property the Exchanger may receive as part of an exchange. “Cash boot” is the receipt of cash and “mortgage boot” (also referred to as debt relief) is a reduction in the exchangor’s mortgage liabilities on a replacement property. Generally, capital gain is recognized (and therefore taxable) to the extent there is boot.

For a fully deferred exchange, an Exchanger must reinvest all net equity and acquire property with the same or greater amount of debt. Compare the relinquished property with the replacement property in terms of:

  1. Value
  2. Net Equity (after deducting costs of sale)
  3. Debt

EXAMPLE 1: The exchangor acquires a property of greater value, reinvesting all proceeds from the sale and increasing the mortgage on the replacement property. The result: there is no boot, no recognized gain, and no resulting tax liability.

Example 1: Total Tax Deferment
Relinquished
Replacement
Example 1: Total Tax Deferment
Price:
Sales Price / Purchase Price
Relinquished
$450,000
Replacement
$600,000
Example 1: Total Tax Deferment
Net Equity:
Relinquished
$200,000
Replacement
$200,000
Example 1: Total Tax Deferment
Debt:
Old/New Mortgage
Relinquished
$250,000
Replacement
$400,000
Example 1: Total Tax Deferment
Taxable Gain:
Relinquished
Replacement
$0

EXAMPLE 2: The exchangor keeps $50,000 of the exchange proceeds, reinvesting only $150,000 as a down payment on the replacement property. Analysis: There is $50,000 of “cash boot” which results in recognized (taxable) gain.

Example 2: Cash Boot
Relinquished
Replacement
Example 2: Cash Boot
Price:
Sales Price / Purchase Price
Relinquished
$450,000
Replacement
$600,000
Example 2: Cash Boot
Net Equity:
Relinquished
$200,000
Replacement
$150,000
Example 2: Cash Boot
Debt:
Old/New Mortgage
Relinquished
$250,000
Replacement
$400,000
Example 2: Cash Boot
Taxable Gain:
Relinquished
Replacement
$50,000

EXAMPLE 3: The exchangor acquires property of a lower value and, while reinvesting all equity in the replacement property, acquires less debt in the process. Result: the exchangor has reduced the debt by $100,000 (“mortgage boot”) which results in a recognized (taxable) gain of $100,000.

Example 3: Mortgage Boot
Relinquished
Replacement
Example 3: Mortgage Boot
Price:
Sales Price / Purchase Price
Relinquished
$450,000
Replacement
$350,000
Example 3: Mortgage Boot
Net Equity:
Relinquished
$200,000
Replacement
$200,000
Example 3: Mortgage Boot
Debt:
Old/New Mortgage
Relinquished
$250,000
Replacement
$150,000
Example 3: Mortgage Boot
Taxable Gain:
Relinquished
Replacement
$100,000