Can I Use a 1031 Exchange to Pay Off a Mortgage?

A Section 1031 exchange permits real estate investors to defer capital gains taxes on the sale of a business or investment property by reinvesting the proceeds into a new, “like-kind” property. This allows for the growth of a real estate portfolio without an immediate reduction in capital due to taxes. Many investors have questions about how existing mortgage debt impacts the transaction, specifically whether the exchange can be used to pay off or reduce leverage. Understanding the rules surrounding debt is necessary to successfully navigate a 1031 exchange and achieve the desired financial outcome.

The Role of Debt in a 1031 Exchange

To achieve complete tax deferral in a 1031 exchange, an investor must meet two requirements related to value and debt. The total purchase price of the replacement property must be equal to or greater than the selling price of the relinquished property. The mortgage on the new property must also be equal to or greater than the mortgage that was on the old property. This ensures the investor’s net financial position is not reduced.

When an investor acquires a replacement property with a smaller mortgage than the one on the property they sold, the Internal Revenue Service (IRS) views this difference as “debt relief.” This debt relief is a form of “boot,” a term for non-like-kind property received in the transaction. Any boot received, including debt relief, is subject to capital gains tax, as the investor has received an economic benefit by being relieved of a liability.

For example, an investor sells a property valued at $1 million with a $600,000 mortgage. To fully defer taxes, they must buy a new property for at least $1 million and take on a new mortgage of at least $600,000. If they acquire a replacement property for $1 million with only a $400,000 mortgage, they have created $200,000 of “mortgage boot,” which is taxable.

The IRS requires that all aspects of the exchange, including the values and liabilities of the properties, be reported on Form 8824, Like-Kind Exchanges. This form is filed with the investor’s tax return for the year the exchange takes place. It is used to calculate any realized gain and recognized gain from boot, and failure to correctly account for debt can lead to an unexpected tax liability.

Calculating Taxable Mortgage Boot

The calculation for mortgage boot is straightforward and focuses on the change in an investor’s debt position. The formula is the mortgage on the relinquished property minus the mortgage on the replacement property. If the result is a positive number, that amount represents the mortgage boot received by the investor and is potentially taxable income.

However, an investor can offset this mortgage boot and avoid the tax. An investor can contribute their own cash into the purchase of the replacement property to make up for the shortfall in debt. The amount of new cash added must be at least equal to the amount of debt relief created. This action replaces the debt with fresh equity, satisfying the IRS requirement that the investor is not “cashing out” of their liability.

For example, an investor sells a property with a $750,000 mortgage. They identify a replacement property, but the new loan they secure is for only $600,000. This creates $150,000 of mortgage boot. To negate this taxable boot, the investor must add at least $150,000 of their own cash at the closing of the replacement property purchase.

This cash-infusion strategy is how an exchange can be used to pay down debt. While an investor cannot use exchange proceeds to pay off a mortgage directly without tax consequences, they can achieve a similar result. By replacing old debt with a smaller new debt and adding personal cash, they lower their overall leverage while deferring capital gains tax.

Strategies for Managing Debt in an Exchange

One strategy for managing debt is to undertake a partial exchange. In this scenario, an investor may intentionally choose to receive some boot, whether as cash or debt relief. They would then pay the applicable capital gains tax on that portion while deferring the tax on the remainder of the gain. This can be a deliberate choice for investors who wish to access some capital or reduce debt and are willing to accept the tax consequence.

The timing of any refinancing activity around a 1031 exchange is scrutinized by the IRS. Refinancing the relinquished property to pull out cash immediately before an exchange can be problematic. The IRS may view this as a step transaction, treating the cash received from the refinance as taxable boot. A similar risk exists when an investor obtains a larger loan on the replacement property than needed and receives cash back at closing, or refinances it shortly after the exchange.

To mitigate the risk of the IRS invoking the step-transaction doctrine, it is advisable to show that the refinancing is an independent financial event. While there is no officially mandated safe-harbor time frame, many tax advisors suggest waiting six months to a year before or after an exchange to refinance a property. This separation in time helps establish that the refinance had its own independent business purpose and was not simply a method to access cash tax-free.