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 Exchangor must reinvest all net equity AND replace the value  (with a new financing, seller financing, or cash) of any loan that was paid off in the sale of the relinquished property. This topic is often confusing for exchangors. The easiest way to think of it is that in order to defer all taxes, you must simply purchase replacement property of equal or greater value that the relinquished property. 

EXAMPLE 1: The exchangor acquires a property of greater value, reinvesting all proceeds from the sale and increasing the mortgage on the replacement property. 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. RESULT: 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
$450,000
Example 2: Cash Boot
Taxable Gain:
Relinquished
-
Replacement
$50,000

EXAMPLE 3: Upon the sale of relinquished property the exchanger pays off mortgage balance and exchangor acquires property of a lower value with sale proceeds. RESULT: the exchangor has reduced the debt by $200,000 (“mortgage boot”) which results in a recognized (taxable) gain of $200,000.

Example 3: Mortgage Boot
Relinquished
Replacement
Example 3: Mortgage Boot
Price:
Sales Price / Purchase Price
Relinquished
$450,000
Replacement
$200,000
Example 3: Mortgage Boot
Net Equity:
Relinquished
$200,000
Replacement
$200,000
Example 3: Mortgage Boot
Debt:
Old/New Mortgage
Relinquished
$250,000
Replacement
$0
Example 3: Mortgage Boot
Taxable Gain:
Relinquished
-
Replacement
$250,000

EXAMPLE 4: Upon the sale of relinquished property the exchanger pays off mortgage balance and combines the sales proceeds with outside cash to purchase the replacement property debt-free. RESULT: the exchangor has offset their debt replacement needs by injecting $150,000 of new cash which results in no tax liability.

Example 4: New Cash
Relinquished
Replacement
Example 4: New Cash
Price:
Sales Price / Purchase Price
Relinquished
$450,000
Replacement
$350,000
Example 4: New Cash
Net Equity:
Relinquished
$200,000
Replacement
$350,000
Example 4: New Cash
Debt:
Old/New Mortgage
Relinquished
$250,000
Replacement
$0
Example 4: New Cash
Taxable Gain:
Relinquished
-
Replacement
$0