Sec. 1031 As A Debt Resolution Strategy

April 29, 2019

Those who fall into debt have a variety of options to select from when trying to climb out. We’ve devoted plenty of time and energy discussing some of the more commonly selected options. We’ve gone over debt consolidation loans, for instance. We also discussed other types of debt relief, including forbearance, settlement and bankruptcy. Each debt resolution option we’ve covered has its own logic and may be suitable depending on the given circumstances. Settlement, for instance, has the benefit of resolving the debt for lower face value and minimizing credit report damage. However, settlement requires a sizable lump sum payment, and may also require hiring an attorney in certain cases. Locating the best option will always depend on a detached analysis of all relevant factors. 

Not every debtor will have the same debt resolution options. Some debtors will have quite a few more options than others. For those with significant real estate investments, it may be possible to resolve debt while also growing wealth at the same time. So far, we’ve discussed the technical aspects of 1031 exchanges in considerable detail. But 1031 exchanges can also be very powerful wealth building tools. In this post, we will explain how 1031 exchanges can be utilized to resolve existing debts and optimize one’s financial situation. For those surveying debt resolution options, a Section 1031 exchange may be hard to decline. 

Cash Boot Can Be Used to Resolve Existing Debts 

In a 1031 exchange, the usual goal is to defer 100% of the gain which would be triggered by a sale. However, this is not always the case. In some situations, investors deliberately choose to take some of the proceeds to fund other things. In such cases, investors pay taxes only on the “cash boot” removed from the exchange. For those with significant capital gains in investment real estate, using boot to resolve debt may be a great strategy. There are plenty of situations one can imagine in which this strategy would make excellent financial sense. Let’s imagine one such scenario.  

Suppose an investor purchases and maintains a rental property for several years. And suppose that during the course of ownership, the property has appreciated greatly in value. Let’s say that the initial value at the time of acquisition was $100,000. But then at the time when the investor contemplates a disposition, the value has increased to $500,000. Let’s also assume that this investor has racked up a significant amount of credit card debt during his or her ownership.

The investor could remove enough boot to cover the credit card debt and then defer the remaining gain. Yes, the investor would incur a liability on the boot. But, taking the boot would allow for the entire debt to be resolve at once. And, because the property had appreciated, taxes would have to be paid eventually in the event of a cash sale. Taking the boot allows the investor to avoid the high credit card interest rates. 

Investors Can Strategically Utilize Mortgage Boot 

Although most boot received is in the form of cash, this is not always the case. If an investor pays off an existing mortgage but buys down in replacement property value, this can constitute mortgage boot. For instance, let’s suppose an investor buys a property with a value of $500,000 and takes a mortgage of $300,000. Then, several years later, the property appreciates to $1 million. The investor may still have mortgage debt, but his or her equity has grown considerably. It may be financially sensible to conduct an exchange, pay off the mortgage and take the tax hit on the boot. Sticking with this hypothetical, suppose the investor sells for $1 million as part of an exchange.

Next, suppose that investor pays off the mortgage balance (of $250,000) and takes the remaining $750,000 and acquires replacement property. Even though the investor will pay taxes on the debt relief, he or she will pay off the entire balance right away. Plus, depending on the mortgage interest rate, the investor may come close to coming out even after paying the tax liability.  

Increased Revenues Can Be Used to Resolve Debts 

Deferring gain is only one of the purposes of a Section 1031 exchange. Another purpose of an exchange is to grow wealth through deferred gains. If an investor conducts an exchange and uses deferred taxes to acquire a larger, better performing property, this enables wealth to be grown faster. This wealth building purpose can also be exploited to pay off existing debt. Suppose an investor sells a property worth $1.5 million and defers 100% of the taxes through an exchange.

Next, suppose that the new property acquired through the exchange yields higher revenues than the previous investment property. The investor can take these higher revenues and use them toward the existing debt. Because the new property was partly financed with deferred taxes, we can see how this is a desirable situation. Instead of cashing out with a tax liability, the investor is gaining higher returns and using those returns to pay off debt. For those who have this as an option, using an exchange as a debt resolution mechanism in this way can be very sensible.  

Our New York City Tax Attorneys Can Help

In future posts, we will return to discuss other debt resolution strategies. Debt resolution is a major focus of Mackay, Caswell & Callahan, P.C. Our attorneys spend a great deal of time helping our clients resolve debts of various kinds. We will return to focus on debt relief programs, debt management programs, back tax debt and other related matters. If you need help with a tax or debt related issue, contact one of our top New York City tax attorneys today. 

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