Suppose you sell a relinquished property for approximately $300,000.00. Can you purchase a replacement property that is valued at $250,000.00 using 1031 exchange proceeds?
Yes, you can, although the replacement property must be equal or it should be higher in value from the relinquished property. It is possible to do a 1031 exchange and purchase a property that is lower value.
If you sell a property that is worth $500,000.00 and purchase a replacement property that is worth $450,000.00, you will have $50,000.00 left. This amount is called “boot.” the boot is part of the proceeds that is not reinvested into the replacement property and that will be taxable.
The tax rate on this boot can be 0%, 15% or 20% as of 2023, depending on which income tax bracket you fall under.
In summary, you can downgrade to a lower-valued property when doing a 1031 exchange but any remaining proceeds will be considered boot and will be taxable.
Now let’s talk about a situation where you sell your relinquished property for $500,000.00 and your proceeds from the sale come out to $400,000.00 after you paid off a $100,000.00 note from the said property. You will still have to purchase a replacement property equal to $500,000.00 or more because the rule is based off of the sales price, not your proceeds.
Let’s say you end up purchasing a replacement property for $400,000.00 using the above mentioned proceeds then, even though, all your proceeds are re-invested into another property, the IRS will still consider the difference in property values, in this case $100,000.00, as taxable and you will end up paying capital gain taxes on the $100,000.00.