Beware of the Debt “Tax Trap” When Doing a 1031 Exchange of Real Estate Assets

At a time when capital gains tax rates have increased, and many taxpayers are also subject to the 3.8% Medicare Tax on certain capital gain property, taxpayers are becoming increasingly interested in pursuing the tax-free exchange provisions of IRC 1031.

While 1031 exchanges have been around and used by taxpayers for many years, there are numerous “tax traps” that potential investors must be aware of, the most common of which is the issue of debt on the relinquished and replacement properties.

Most exchanges are facilitated by Qualified Intermediaries (“QI”), which are not agents of the taxpayer, but are used to take title to the relinquished property, sell it to a third party, collect the proceeds, and purchase the replacement property and then transfer it back to the taxpayer.  When accomplished within the applicable guidelines established in the Internal Revenue Code and Income Tax Regulations, the taxpayer will be permitted to defer the gain on the sale of the relinquished property until the replacement property is sold. 

In Barker, 74 TC 555 (1980), the Tax Court held that proceeds from the disposition of relinquished property can be used to pay off debt on that property without triggering gain if the taxpayer incurs or assumes a liability on the purchase of the replacement property that equals or exceeds the debt on the relinquished property.

When the relinquished property is encumbered with debt, as is the case with most real estate assets, and when no additional cash other than the net sales proceeds of the relinquished property is going to be invested by the taxpayer, it is important to make sure that the replacement property is encumbered with at least as much debt as there was on the relinquished property.  If not, the excess of the debt on the relinquished property over the debt that is on the replacement property will be considered “boot” and gain will have to be recognized on the lesser of the actual gain or the “boot” received. 

 Be sure to consult with your tax advisors before entering into any sales transaction, but especially one in which you are trying to take advantage of the tax-free exchange provisions.