1031 Exchange

[Burke]

If a 1031 exchange is done, transferring all equity from the old property into the new one which is more expensive, and it meets all the safe harbors for a legitimate tax-deferred exchange -- then the TP borrows the equity out of the new property, does this disqualify the exchange? It seems to circumvent the intent of the the TFE and put the cash in the principal's pocket which would otherwise be taxable, so it doesn't SEEM right. On the other hand, it is a mortgage secured by the property, which means normally it is not taxable and must be repaid, so it may be okay. So in theory, if it is OK, can it also be done simultaneously at closing? Is there a time frame in which he must wait to do this? Is he prohibited from mortgaging the property beyond his mortgage in the old one, since debts must be equalized in an exchange? It may hinge on this requirement, but for how long? I have researched all the materials I have on this and cannot find anything that says it specifically is forbidden, but it also seems that I have seen something regarding this in the past. Any references would be appreciated.

[mactoolsix]

Mortgage Boot

If done during the exchange, the equity out is going to be considered Mortgage Boot. For example:

Property Old vs. New
S / Price. 500,000 vs. 550,000
Mortgage 100,000 vs 350,000
O / Equity: 400,000 vs 200,000

Realized Gain
Sales price 500,000
Less: Basis 100,000
Less: Expenses 1,000
Realized Gain 399,000

Recognized Gain
Change in Equity 200,000
Decrease in Liab. 0
Less: Expenses. 1,000
Recognized Gain 199,000

Increasing the mortgage on the new property will increase the new equity, thus more of the gain will be recognized. No matter how you mask it, cash out will be considered boot.

Here's a link to a quick like-kind exchange calculator:

http://www.dinkytown.net/java/LikeKindExchange.html

Mike

[Burke]

Increasing the mortgage on the new property will increase the new equity, thus more of the gain will be recognized. No matter how you mask it, cash out will be considered boot.Mike

Got it. And that makes sense to me. Now, the further question is, can the new equity never be increased in the future without triggering the realization of taxable income on the prior exchange? At least, until all gain is recognized? In other words, the TP cannot go back several years later and take equity out by refinancing, second mtge, etc.

[jimmcg]

[QUOTE=Burke;108408]If a 1031 exchange is done, transferring all equity from the old property into the new one which is more expensive, and it meets all the safe harbors for a legitimate tax-deferred exchange -- then the TP borrows the equity out of the new property, does this disqualify the exchange? It seems to circumvent the intent of the the TFE and put the cash in the principal's pocket which would otherwise be taxable, so it doesn't SEEM right. On the other hand, it is a mortgage secured by the property, which means normally it is not taxable and must be repaid, so it may be okay. So in theory, if it is OK, can it also be done simultaneously at closing? Is there a time frame in which he must wait to do this? Is he prohibited from mortgaging the property beyond his mortgage in the old one, since debts must be equalized in an exchange? It may hinge on this requirement, but for how long? I have researched all the materials I have on this and cannot find anything that says it specifically is forbidden, but it also seems that I have seen something regarding this in the past. Any references would be appreciated.[/QUOTE


There are methods whereby one can legitimately "get the cash out" of property involved in a qualified 1031 trans either before, during, or after the transaction in question. Suggest you do an internet search using the keywords 1031 trans, refinancing, etc. This will give you an overview of the various methods and proceedures involved in avoiding constructive receipt, step transaction rule, etc. Unfortunately this is a very involved area and should be handled by someone quite adept in the area.

[Burke]

There are methods whereby one can legitimately "get the cash out" of property involved in a qualified 1031 trans either before, during, or after the transaction in question. Suggest you do an internet search using the keywords 1031 trans, refinancing, etc. This will give you an overview of the various methods and proceedures involved in avoiding constructive receipt, step transaction rule, etc. Unfortunately this is a very involved area and should be handled by someone quite adept in the area.

Thank you for the info from both responders. Found exactly that situation in an article in Broker's Magazine which covered the topic and answers my question.