We receive calls daily from investors curious about Delaware Statutory Trusts (DSTs) and 1031 exchanges. Today we’ll talk about an essential requirement to complete a fully tax-deferred exchange.
What Does Equal or Greater Mean?
I am planning to sell an investment property and purchase a new investment property. I want to complete a 1031 exchange to defer the capital gains taxes and have more cash to reinvest. I understand there are strict requirements for the value of my new property. What is equal or greater?
Equal or Greater Replacement Property
“Equal or greater” refers to the amount of exchange funds required to acquire a replacement property in a 1031 exchange. To completely defer taxes owed on capital gains, your replacement property acquisition cost must be equal to or greater than the value of your exchange funds. The value of your exchange funds typically represents the equity, the debt and any profits earned from the sale of a relinquished investment property.
Many assume “equal or greater” means that the purchase value of the replacement property must be equal to or greater than the sale value of the relinquished property. This, however, is inaccurate. 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 that can be paid using exchange funds include sales commissions, legal fees, escrow fees, inspection fees, title insurance fees, recording fees, document fees, notary fees and others. Expenses that cannot be paid using exchange fees include utility costs, mortgage points, mortgage insurance, property insurance, HOA dues, property repairs or termite work and others.
Many investors have found that 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.
Example of a 1031 Exchange
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 sell 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 or Greater to Your Exchange Funds?
Ensuring that the replacement property value is equal to or greater than the value of your exchange funds will help you prevent incurring taxable boot when you complete your exchange. The value difference between a property and the one being exchanged is referred to as a boot. If your replacement property is of lesser value than your exchange funds, the difference is taxable — this is called the cash boot.
If the transaction is completed using non-like-kind or personal property, the earnings are also boot and ineligible for a 1031 exchange. If you’re determined to sidestep capital gains tax as a 1031 exchange allows, the equal or greater rule is an absolute requirement.
Bottom line: In a 1031 exchange, you are always 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.
Find Investment Properties With 1031 Crowdfunding
When you create an investor account at 1031 Crowdfunding, you gain access to our extensive marketplace of 1031 properties. Use our platform to find properties of equal or greater value and allow our expert team to guide you through the exchange process. Our team and services can help you with identification and closing in less than a week, ensuring you stay within the 1031 deadlines for tax deferral.
Get started at 1031 Crowdfunding and create an investor account today.
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