Understanding Debt in a Like-Kind Exchange
How Much Debt Do You Really Have to Replace?
How many times has an advisor told you that you must replace the same amount of debt that was paid off at the closing of your relinquished property with new debt on your like-kind replacement property?
You are not alone if you are frustrated by this question. The amount of debt you need to replace in a tax-deferred exchange transaction has always created confusion among advisors. It is simply an educational problem. The majority of legal counsel, tax advisors and Qualified Intermediaries believe to this day that you are required to replace the same amount of debt that was paid off at the closing of your relinquished property with new debt on your like-kind replacement property equal to or greater than the amount paid off. This is simply not true.
You must acquire one or more like-kind replacement properties that are equal to or greater in net purchase value than the net sales value of the relinquished property(ies) that you sold.
You must also reinvest all of the net cash proceeds from the sale of your relinquished property.
You will need to obtain new debt or invest additional cash equal to the difference between the net purchase price and the reinvested equity. You do not have to replace the debt. You can always invest more cash into the purchase of the like-kind replacement properties if you like.
Always consult with your financial advisor regarding investing additional cash into your real estate portfolio. Additional cash investments essentially become trapped in the investment property and can not be withdrawn without creating a taxable event unless you refinance the investment property and pull cash out with new debt.
Let's assume that you dispose of investment property with a net sales price of $100,000 and you buy like-kind replacement property with a new purchase price of $90,000. You didn't buy equal or up value, but actually traded down in value by $10,000.
The amount that you traded down by is called boot and is first applied to any depreciation recapture income tax liabilities and then to any capital gain income tax liabilities. Your cost basis is not prorated for income tax liability purposes.
You will be able to defer 100% of your income tax liabilities as long as you: (1) exchange equal to or up in value, and (2) reinvest all of the net cash proceeds. The difference will be the correct amount of new debt or cash investment.
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