How Borrowed Funds Affect Your Exchange
So you have an investment property you purchased for next-to-nothing and it’s appreciated to two- or three- times your initial investment. But back then when you were just starting out, you could barely afford the price tag, so you borrowed a big chunk because you were certain it was a sure thing. Or maybe you chose to keep your cash so you could improve the property. Either way, you took out a loan.
Today you decide you can afford to exchange into a property that’s priced twice as much as what you can sell your little money-maker for in order to get higher income and a higher return. You know, of course, that you must “exchange up,” meaning that you need to find a replacement property that’s equal-to or greater-than the value you’re relinquishing. But what about that loan you took out? How might it affect your 1031 exchange?
The truth is that the amount you borrowed must also be exchanged, even if the loan has since been paid off. When you sell your relinquished property, your replacement property must have matching or greater borrowed funds to qualify for a IRC 1031 exchange. So make sure you pencil in the loan you’re going to have to obtain before you start mentally moving in to your dream replacement.
Here’s an example:
Relinquished property (a.k.a. your initial investment property)
Original purchase price $400,000
Original loan amount $300,000
Appreciated market value $800,000 (sales price)
Replacement property (a.k.a. your dream investment property)
Purchase price $800,000 (more or less, depending on your basis and depreciation)
Loan amount $300,000 (or more)
Why would you exchange up? Many reasons come into play which you should discuss with your tax professional. Is the depreciable life of your original property coming to an end? A replacement property would give you another 27.5 years of depreciation. Is the return on your original property equitable or better than the potential return you could be getting in this market? Do you own the property with partners or family members who want to do other things with their money? As long as you own the property as individuals, you can exchange your portion of the property into another investment property you own without all the compromising that comes with multiple owners, and you get to control your own destiny. Different rules apply for corporations and LLC’s; email me for more if you’re interested in discussing those entities’ exchange parameters.
If you are a first time borrower it is imperative that you have a checklist of essential questions that you need to ask each and every lender. The answers to these questions will provide a valuable reference to base your comparisons on. What’s the interest rate? Knowing this is crucial.