The fundamental rule of all 1031 exchanges is: In order to defer all income tax liability, you must trade:
1. equal or up in value (minus direct selling costs) and
2. equal or up in equity.
The IRS reasoning behind this rule is that you, as seller, usually receive two benefits when you sell a property:
1. You receive the net proceeds.
2. Your mortgage is paid off.
Debt relief (mortgage payoff) is treated by the IRS as income. If someone pays a debt for you (or forgives a debt owed by you), the IRS treats this as income. If, in a 1031 exchange, you only reinvest your net sale proceeds, and you have also received a mortgage payoff, then you will not defer 100 percent of your income tax liability.
Naturally, the value of a property is set by the sales price, and therefore is rather inflexible. Not so with the equity. Equity is a constantly moving target. For purposes of your 1031 exchange and meeting Part 2 the aforementioned rule, equity is often roughly equal to net sale proceeds. Thus, 100 percent of net proceeds must be used as down payment on your replacement property.
Because equity is flexible, planning opportunities are available to you.
Remember: Borrowed money is never treated as taxable income, because it must be repaid. If—before you sell your relinquished property, and for legitimate business reasons—you place new financing on your relinquished property, then your equity and net sale proceeds will be reduced. You can thereby put tax-free cash (borrowed money) in your pocket before the sale, while still moving 100 percent of your reduced equity into the replacement property. Similarly, if after you complete the purchase of your replacement property, you refinance the new property and borrow additional cash, this is also tax-free money to you.
The first of these two strategies is easier to accomplish, while the second one is looked upon more favorably by the IRS. Both of these strategies add some tax risk to the tax-deferred status of the 1031 exchange.
Who can benefit from these strategies? When reducing your equity in your relinquished property prior to sale, you must keep in mind that you must leave enough net proceeds in the 1031 exchange to meet the down payment requirement of your replacement property. When refinancing your replacement property, you must satisfy the lender of your debt to income ratio. So this strategy is limited by the amount of your equity and your strength as a borrower. Nevertheless, these are useful and powerful strategies for the exchanger with substantial equity and other investment opportunities outside of the 1031 exchange.
Not all 1031 exchanges are plain vanilla. Some people prefer Rocky Road.