Q: Do I have to reinvest more than my equity (sales price less mortgage) when I sell an investment real property to use Section 1031 to defer all of my gain on the sale?
A: Yes. We often get calls from potential 1031 clients who have been told, or believe, that if they just reinvest their equity on a sale, they can both reduce their debt and also defer the tax on any gain in the sale. That is not correct. When your mortgage is paid off, that is treated as if you received cash in the amount of the payoff. This is referred to as “mortgage boot.” Each dollar of actual cash received, and each dollar of mortgage boot, will be taxed to you, on a first dollar basis, up to the total amount of gain you have in the sale. You can offset mortgage boot (and not have to pay tax on the offset amount) when you acquire replacement property in the 1031 exchange by either borrowing a new mortgage or putting cash of your own into the replacement property. You cannot offset cash received on the sale, however. The easiest way to think of this is that if you want to defer the entire gain on a sale eligible for Section 1031 deferral, the replacement property will need to have a cost equal to or greater than the property sold in the exchange.
Q: Do I have to reinvest more than my taxable gain on the sale of an investment property to successfully defer the gain under Section 1031?
A: Generally, yes. This issue is similar to the previous question. For example, if you bought a property for $100, and then sold it for $200, you would have $100 of taxable gain. You must reinvest the entire $200 sales price to defer all of the gain under Section 1031. If you kept $50 of the sales price, and reinvested $150 in replacement property, you would pay tax on the $50 cash retained, but the other $50 of gain would be deferred under Section 1031 and would be reflected in the tax basis of your replacement property.
Q: Can I buy a property, intending to fix it up some, and then sell it for a profit and defer the gain on the sale using Section 1031?
A: No. This is sometimes referred to as “flipping.” Flipping is not eligible for Section 1031 because Section 1031 does not apply to property held for sale, instead of investment. A person who buys a property with the intent to sell it soon after the purchase generally is holding the property for sale, and not investment. Only real property held for investment or use in a trade or business will qualify under Section 1031.