What Does It Mean If a Replacement Property Has to Be Equal or Greater?

By Peter A. Elwell, CFA | May 29, 2023

A 1031 exchange is a vehicle many investors use for tax deferrals on capital gains. Section 1031 of the Internal Revenue Code by the Internal Revenue Service (IRS) has several requirements for defining a 1031 exchange. One such requirement is that the replacement property is of equal or greater value to the investor’s exchange funds. This post explains what “equal or greater” means in the context of a 1031 exchange.

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What Is an Equal or Greater Replacement Property in a 1031 Exchange?

“Equal or greater” in the 1031 exchange debt rules refers to the amount of exchange funds required to acquire a replacement property in a 1031 exchange. The cost of acquiring your replacement property has to be equal or greater to your exchange fund value to defer taxes on capital gains.

Your exchange fund value typically represents any profits earned from selling the relinquished investment property, the debt, and the equity. In addition, the replacement property has to be a like-kind property as defined by its characteristics, not grade or quality.

Many assume a 1031 exchange of equal or greater value means that the purchase value of the replacement property is required to be equal to or greater than the sale value of the relinquished property. This, however, is not entirely true.

Transaction fees from the sale of a property will reduce the value of the exchange funds, so the purchase price of the replacement property will not have to evenly match the sales price of the relinquished property. Likewise, transaction fees required for the purchase of the replacement property can be paid using exchange funds, also lowering the necessary value of the purchase price.

Expenses and fees also affect the 1031 exchange replacement property value. Expenses that can be paid using exchange funds include:

  • Sales commissions
  • Legal fees
  • Escrow fees
  • Inspection fees
  • Title insurance fees and premiums
  • Recording fees
  • Document fees
  • Notary fees
  • Filing fees
  • Qualified intermediary fees
  • Broker’s commission
  • Escrow fees

Expenses that cannot be paid using exchange fees include:

  • Utility costs
  • Mortgage points
  • Mortgage insurance
  • Property insurance
  • Property repairs such as termite work
  • Property taxes
  • Homeowners Association (HOA) dues
  • Financing fees

Investors must identify a replacement property equal to or greater than the exchange property within 45 days.

The exchange must be completed within 180 days. Investors can identify potential properties using the:

  1. Three-property rule to identify three properties as potential exchange properties regardless of their market value.
  2. Two-hundred percent rule to identify any number of replacement properties with a cumulative value of less than 200% of the value of the sold property.
  3. Ninety-five percent rule to identify several properties as long as the investor can acquire properties valued at 95% or more of their total.

Many investors have found that Delaware Statutory Trusts (DSTs) help to simplify the exchange process by eliminating the risk of excess exchange funds. Because acquiring beneficial interests in a DST property does not require additional acquisition fees, exchange investors do not have to estimate a portion of their exchange funds for use on acquisition fees. Instead, once exchange funds are calculated, the total can be used in one transaction to purchase interests in the DST.

Equal or Greater Replacement Property in a 1031 Exchange Example

The process for a 1031 exchange requires an understanding of a property’s current market price, and how much the real estate investor spent on the property initially. The sale price of a currently owned property may be $550,000, but the investor purchased the property for $500,000. 

In this example, the investor has $225,000 in equity and $275,000 in remaining debt. The $550,000 sell price covers the debt, pays back the equity and covers $30,000 in transaction fees. The investor nets about $20,000 in profits. The value of the exchange funds is the total of equity, debt and profits — $520,000.

If the investor anticipates about $20,000 in acquisition fees, the property they exchange can be around $500,000 to qualify for a 1031 exchange. This equal or greater rule also applies to debt and equity. This qualification requires the investor to take on $275,000 in debt and spend $245,000 at a minimum. An investor can also take on another combination of debt and equity to equal $520,000.

The investor also has the ability to purchase more than one property with these earnings, as long as the combined value is of equal or greater value to the equity, debt and profits. If an investor chooses to purchase a property with greater value, they’ll need to contribute personal funds or take on additional debt outside of the sale. This instance still qualifies for a 1031 exchange.

What Happens When Your Replacement Property Is Not Equal to or Greater Than Your Exchange Funds?

Help prevent incurring taxable boot

Ensuring that the replacement property value is equal to or greater than the value of your exchange funds will help you prevent incurring a capital gains tax liability when you complete your exchange. The value difference between a relinquished property and the replacement property is referred to as a boot. A tax liability may be created if:

  • Your replacement property is of lesser value than your exchange funds.
  • The investor’s 1031 debt replacement on the replacement property does not match that on the relinquished property.
  • The exchange is completed using a non-like-kind or personal property.

An exchange with boot is considered a partial exchange, as you must pay taxes on the boot. If you’re determined to sidestep capital gains tax as a 1031 exchange allows, the equal or greater rule is an absolute requirement.

The bottom line is that in a 1031 exchange, you are allowed to contribute additional funds to acquire a property valued greater than the value of your exchange funds. However, you must acquire a property with an acquisition value at least equal to that of your exchange funds to avoid capital gains taxes. Furthermore, you must reinvest all sales proceeds from the relinquished property into the new property if you want to avoid boot and taxable gains.

Learn More About 1031 Exchanges With 1031 Crowdfunding

The “equal or greater” requirement is critical for investors, as following this guideline can defer capital gains taxes. 1031 Crowdfunding helps investors who need to find a suitable property for a 1031 exchange. We have an extensive online marketplace of properties for you to choose from.

Register for an account with 1031 Crowdfunding today to diversify your real estate portfolio while following IRS requirements. Read our blog for more information about 1031 exchanges.

Learn More About 1031 Exchanges With 1031 Crowdfunding

This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements are speculative in nature and involve a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC, member FINRA, SIPC.

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