How Much Do I Have to Reinvest in My 1031 Exchange?

This is a very common question that real estate investors ask when considering structuring a 1031 Tax Deferred Exchange transaction.  Unfortunately, there are so many vague or incorrect answers in circulation today that it gets very confusing when trying to understand the true and correct answer to the issue.

Reinvestment Requirement

The first question that you need to ask yourself is whether or not you you want to defer all of your capital gain taxes and/or depreciation recapture taxes or just some of your income tax liability?  Do you want to buy more real estate or less?  Generally, you will want to defer all of your taxes, but you can complete a partial 1031 Exchange and only defer some if you wish. 

Deferring All Of Your Taxes

If you want to defer all of your capital gain taxes and depreciation recapture taxes, you must reinvest your entire net sales price.  Your net equity doesn't matter; only your net sales price.  This means that you take your actual sales price ("gross sales price") and substract your routine closing costs to arrive at your net sales price.  This is the amount that you must reinvest. 

You often hear people say that you only have to reinvest your cash equity and your debt/mortgage, but this formula often inadvertently ignores certain deductions from your gross sales price that are not routine closing costs and therefore skews the amount required for reinvestment.

Trade Equal or Up in Value

You must acquire one or more replacement properties that are worth at least this much (or more, you can always trade up and acquire more property).  You must also reinvest 100% of your net equity (net cash) in your replacement properties.  You can always pull cash out upfront or at the back end of your 1031 Exchange, if you want to, but it will result in taxable boot. 

Partial 1031 Tax Deferred Exchange

You can trade down in value if you choose to do so, but you will trigger some taxable boot and have to pay depreciation recapture taxes and/or capital gain taxes on the amount that you trade down by.  This can often be a tactical strategy when dealing with a distressed portfolio of properties. 

For example, you may sell a $5 million portfolio of investment property and trade down through a 1031 Tax Deferred Exchange by acquiring only $3.5 million in replacement properties in order to put you in a position that is easier to service (i.e. reduction of debt).  This strategy allows you to defer some of your capital gain taxes, but also reduce the amount of your debt service.