Trading Down in Value on Purpose in My 1031 Exchange

This is a follow-up blog post to my last post regarding trading down in value or amount when completing a 1031 tax deferred exchange. Trading down in value is perfectly O.K. as long as you understand the income tax consequences. In fact, it might be advisable under certain circumstances to trade down in value on purpose as part of your income tax planning.

1031 Tax Deferred Exchange

Generally, you must trade equal or up in value based upon the net sales price when completing your 1031 tax deferred exchange. This means that if your net sales price after routine closing costs is $1,000,000 you must acquire one or more replacement properties for a total purchase price of $1,000,000 or more. You must also reinvest 100% of your cash proceeds (equity) generated from the close of your relinquished property.

Trading Down on Purpose

However, your tax advisor may advise that you trade down in value on purpose as part of your income tax planning. You may wish to complete a partial 1031 tax deferred exchange for any number of reasons, including:

• You may have suspended passive activity losses that would offset the depreciation recapture and/or capital gain recognized by trading down.
• You might have another capital loss on the sale of other property that could also offset the depreciation recapture and/or capital gain triggered by a partial 1031 tax deferred exchange.
• Or, you may simply wish to pull some cash out for other uses or to increase your cash reserve for unexpected expenses.

Income Tax Consequences

Trading down in value creates boot, which will generate an income tax liability. The amount of boot generated will first be applied toward any depreciation recapture that you might have. Any remaining boot will be applied toward your capital gain once your entire depreciation recapture has been recognized and taxed.  Your cost basis is not prorated, so the entire amount of your boot will be taxable until you have fully recognized all of your income tax liabilities.

It is possible to trade too far down in value and trigger all of your income taxes, in which case the 1031 tax deferred exchange will not provide any tax deferral benefits.  It is important to understand exactly what the income tax consequences will be before you begin your 1031 tax deferred exchange.