We received this inquiry from a successful Realtor® in a resort Community in Maryland- Can You Do a Reverse Like-Kind Exchange for a Replacement Property Worth Less than the Original?
Q: Let's say you have a place on the market for $1,350,000 and want to buy a place that is less. Can you still perform a 1031 exchange? Furthermore, let's say you want to take cash out of the place for sale to buy the other prior to the sale of the one your selling, basically a reverse exchange of a property substantially less. Is this possible as well?
A: There are three questions in here:
1) Whether your client is the ideal prospect for a Reverse Exchange? That is an issue we address outside the scope of this blog but in full detail on our site. Some clients are ideal for reverse exchanges some are not.
2) Whether you can do a partial exchange and buy a replacement property for less value than your relinquished property. Absolutely yes you can do that. However, you would want to analyze your cost basis to make sure you do not trade so far below your value that you're not getting any benefit from the 1031. For instance if you paid $500,000 and sold for $1,300,000 you would get no value by buying $400,000 worth of replacement property. 1031 exchanges defer the liability on gain above the basis not on a "pro rata basis". So in this case you wouldn't just be deferring taxes on the $400,000 amount. This area is black and white; it all depends on your basis.
3) The second inquiry, whether you can pull equity out of the relinquished property, is more of a red flag issue for the IRS. First, any refinance of the relinquished property should be as close as possible to one year before sale. The IRS frowns on the refinancing of relinquished properties and generally prefers the refinance of replacement property. The rationale is there is less risk of a predetermined cash out of the replacement property and more likelihood that this transaction is an "independent" transaction. If not the IRS views it as a cash out. It would be preferable for you to get an unsecured line or a line on another property to buy the replacement.
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