In a 1031 exchange, there are three general accounting benchmarks that you want to be cognizant of – value, equity, and debt.
Value, Equity, Debt
- In order to cover all of the gain you have to buy your replacement property of equal or greater value.
- The next benchmark is you have to reinvest all of your equity or net proceeds into that new replacement property.
- Finally, to the extent that you are discharged or relieved of debts associated with the relinquished property, you need to acquire a replacement property and take out new debt sufficient to offset the old debt relief. Or if you’re flush with cash you can also invest additional cash out of your pocket to offset some or all of that debt relief.
The problem comes when people sell their relinquished property and they engage in seller-backed financing. Perhaps the buyer doesn’t have enough money for the down payment and they say to you “hey why don’t I borrow $10,000 or $15,000 from you and I’ll give you a note at the time of closing for that amount?”
Well if the seller that’s doing the exchange receives any property other than like-kind real estate as part of the exchange that is called boot, and boot is taxable. If the seller receives a note for $10,000 or $15,000 they’ve just received $10,000 or $15,000 worth of boot.
Insulating the Seller
In order to insulate the seller from receiving that boot we would have all of the proceeds (both the cash and the non-cash proceeds) go to the qualified intermediary so that it can be applied for the purchase of the new replacement property. If the seller of the new replacement property likes the idea of receiving the cash but isn’t so enthralled with receiving the note you can then have the exchangor substitute in cash into the exchange account for the face value of the note so that the intermediary has all cash in the exchange account to apply for and use to purchase the replacement property.