Liabilities Lend Flexibility to Exchanges

In a 1031 exchange, one rule is that cash (net equity) from the relinquished property must be reinvested entirely in the replacement property.

To the extent cash (net equity) is not reinvested, it will be taxed to the extent of gain.

Taxpayers often complain about this reinvestment of cash rule.
They wish that cash used for their down payment, improvements, or principal pay down should be returned to them without taxation.

This reasoning makes sense but the IRS rule stands.
This rule tends to trap cash in the real-estate investment.

Liabilities and real estate go together .

While cash (net equity) must be reinvested, liabilities can be used to creatively adjust net equity.

Either liabilities on the relinquished property can be increased prior to an exchange, or liabilities on the replacement property can be increased following an exchange to adjust the taxpayer's cash position.

Certain tax authority suggests that increasing liabilities on the relinquished property is riskier than increasing tax liability on the replacement property.

It is easier for the IRS to argue that liabilities placed on the relinquished property in anticipation of sale look like an attempt to circumvent the reinvestment of cash rule stated above.

It is harder for the IRS to argue that liabilities placed on the replacement property after its purchase are an attempt to circumvent the reinvestment of cash rule.

Whether the taxpayer's cash position is adjusted before or after the exchange, liabilities can be used creatively to free cash from the exchange.

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