In short
No rule says replace your mortgage. The rule is that debt paid off at closing counts as money received unless new debt or your own cash covers it. The short version.
Nothing in section 1031 says you must take out a new loan. What the rules say is that a loan paid off at closing counts as money you received, and money received is taxed up to the gain. New debt on the replacement cancels it, and so does cash you add from outside the exchange. “Debt replacement” is shorthand for covering that figure one way or the other. Here is the rule, the arithmetic, and the one direction it does not work.
The rule is about money received, not about loans
Section 1031(b) says that when you receive money or other property in addition to like-kind property, gain is recognized “in an amount not in excess of the sum of such money and the fair market value of such other property.” Reg. section 1.1031(b)-1(c) then says that “consideration received in the form of an assumption of liabilities (or a transfer subject to a liability) is to be treated as other property or money.” Your buyer taking the property free of your mortgage, by paying it off from the price, is exactly that.
The same paragraph adds the offset: consideration you give “in the form of an assumption of liabilities (or a receipt of property subject to a liability) shall be offset against consideration received in the form of an assumption of liabilities.” Debt you take on cancels debt you shed.
Three ways to cover the debt that comes off
Reg. section 1.1031(d)-2, Example 2, adds the second offset: “consideration given in the form of cash or other property is offset against consideration received in the form of an assumption of liabilities.” So the debt relieved can be covered by:
- a new loan on the replacement property, including seller financing or a loan you assume;
- cash you bring from outside the exchange; or
- your share of the nonrecourse debt inside a Delaware Statutory Trust, which is how a leveraged trust covers the loan on a building you sold. See can a DST’s loan count as replacement debt.
The third route is the reason a cash out DST exists. Because it is highly leveraged, a small allocation of proceeds can carry a large share of debt, which covers the debt figure and leaves the rest of your equity free for low-leverage investments. The structure is explained in zero cash flow DSTs and the deleveraging use in deleveraging with a 1031.
The regulation’s own example, then a hypothetical
The regulation’s Example 2 gives up property subject to a $150,000 mortgage, takes property subject to an $80,000 mortgage and pays $40,000 of cash. The $150,000 of relief is reduced by the $80,000 assumed and the $40,000 paid, leaving $30,000 treated as money received. That is the whole mechanism.
Hypothetical, round numbers: you sell for $1,000,000 with a $400,000 loan, so $600,000 of equity reaches the intermediary. Buy a $1,000,000 replacement with the $600,000 and a $400,000 loan, and the debt figure is covered. Buy the same property with the $600,000 and $400,000 of your own savings, and it is covered with no loan at all. Buy a $600,000 property free and clear with the intermediary’s money alone, and $400,000 of debt relief is unreplaced and taxed up to your gain. Run your own numbers with your CPA.
Where it shows on the form
Line 15 of Form 8824 includes “net liabilities assumed by the other party,” defined in the instructions as the excess of liabilities assumed by the other party over “(a) any liabilities you assumed, (b) cash you paid to the other party, and (c) the FMV of the other (non-like-kind) property you gave up.” Line 20, recognized gain, is generally the smaller of line 15 and your realized gain. If line 15 is zero, nothing is recognized.
The one-way street
The offset runs one direction only. Example 2 of Reg. section 1.1031(d)-2 shows that the other party’s $80,000 of debt relief is offset by the $150,000 of debt assumed, but cash received is not offset by debt assumed. If you take $50,000 of cash at closing and borrow $50,000 more on the replacement, the new loan does not cure the cash; the $50,000 is still money received. Taking cash out is a separate decision, covered in intentional boot.
The longer treatment, with the equity side and the purchase price target, is the 1031 exchange equation guide, and the question most people actually ask is answered in do I have to replace my mortgage or can I add cash.
What to do now
- Get the loan payoff figure from your lender before you list; that number, not the original loan, is what you cover.
- Decide between new debt, outside cash and a leveraged trust interest before you identify, since it changes what you identify.
- Have your CPA check line 15 from the draft settlement statements before the replacement closes.
