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Uncle Sam will always take his tax bite, but through proper management of your assets, you can make that bite as small as possible. A 1031 exchange, or “Like-Kind” exchange is one of the most effective ways to trade assets while minimizing or even eliminating the tax burden on the transaction. Not all transactions qualify as Like-Kind exchanges, however, and even those that do often generate some taxable income. To get the most out of the Like-Kind exemption, make sure to replace any debt on the original asset.

What does it mean to replace debt?

Replacing debt means making sure that you have the same value of debt on the new property as you had on the old one. If the value of debt on the new property is lower that that on the old one, the government will treat the difference between the amounts of debt as income, which will not be tax exempt. Say that you are exchanging one house for another and the original house had a $750,000 mortgage on it. If the new house only has a $600,000 mortgage on it and you do not take any steps to replace the value of the other $150,000, you have technically made $150,000 in income and must pay taxes on it. If the new house has a $750,000 mortgage on it, however, you will not have to pay any taxes even if the overall net value of your assets increases.

How do I replace debt?

Although many investors replace the old debt with new debt in the same form, all that is necessary is that the new property hold the same value of debt as the old one. Investors have a wide range of options to reproduce this value, including:

Cash – Investors who do not want to maintain the same amount of debt can replace the value of the debt with cash.
Ordinary Loans – The investor can take out a mortgage or other loan from a traditional lender to substitute any loans on the old property.
Carryback Notes – Also known as seller finance, this occurs when the person selling the property agrees to pay for your purchase. Essentially, you’ll be in debt to the seller rather than to a bank.
Private Money Loans – You can borrow money from an individual or from a private organization and use that to finance your purchase.
Investors are free to combine as many of these methods as they want when replacing the value of their debt. If your original property had a $750,000 mortgage on it, for example, you can take out a $500,000 mortgage on the new property, borrow $150,000 from a private organization, convince the seller to cover $50,000, and pay for the remaining $50,000 in cash. As long as the value of the original debt is covered, your investment will be tax free.

Listen to MANSARD President, Jeremy Cyrier, CCIM & MANSARD Commercial Real Estate Advisor, Howard West discuss tips for avoiding common mistakes investors make in a 1031 exchange.  Click here to watch video.

For more information, contact Jeremy Cyrier, CCIM at jeremy@mansardcre.com or by phone at 617-674-2043.