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1031 Exchanges – Don’t Get the Boot!

Watch the boot in a 1031 exchange!!

Watch the boot in a 1031 exchange!!

Orange County, CA – A 1031 exchange may be an odd thing to see showing up on a website all about mortgages, but there’s good reason. If you’re unfamiliar, a 1031 exchange is an IRS-approved financial transaction wherein a person sells one piece of property and uses the proceeds to purchase a different property of ‘like kind’. The property cannot be a primary residence or a vacation home; it must be a business space, rental, farm, or other money-making property.

If the exchange is performed properly, no capital gains tax is charged on the sale of the first property. In essence, the exchanger must take precision care to ensure that the two properties really are of ‘like kind’ by the legal definition, because any differences can cause problems.

Like Attracts Like

You have to be conscious of something referred to as boot. Boot is the fair market value of “other property” received by the taxpayer in an exchange. For example, let’s assume you sell a rental home and you purchase a different rental home but you removed all of the appliances from the one you sold and then purchased one with all of its appliances. You may be charged capital gains tax on the value of those appliances. They are not of ‘like kind’ with the property you sold.

Similarly, if you sell a home that has a higher value attached to it and then purchase a home with a lower value. You essentially just netted yourself capital gains equal to the difference in value. You’ll have to pay for that. You are buying down and reducing your capital gain exposure.

For example, let’s say you have a capital gains tax rate of 15%, and a rental home worth $700,000 with a mortgage debt of $500,000.  You sell it and purchase a similar rental, worth $600,000, but with mortgage debt of only $400,000. That $100,000 ‘boot’ is going to cost you $15,000 in capital gains tax.

Avoid The Tax by Switching Mortgages

There are several strategies for avoiding boots and thus minimizing taxes. One of them is to consistently trade up or trade across– by purchasing a property that costs the same as or more than the property you sell. Like the above example, let’s say you trade a $700,000 rental home with $500,000 in debt for a $700,000 that’s free and clear. You use the $200,000 of equity toward the new purchase and you get the other $500,000 in the form of a mortgage from a lender like us.

According to the IRS, you’re golden. You performed a 1031 exchange and got like value for like value ($200,000 in home equity for $200,000 in home equity). The details of how the mortgages work out are irrelevant to the IRS, because all they look at is the value you received for the value you sold. So if you happen to get a better interest rate, lower monthly payments, or other advantages by swapping mortgages, that’s an extra bonus for you.

Contact me to add or re-establish a mortgage on your next property in your exchange.

Scott Storace

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