Can 1031 Proceeds Pay Off Other Debts at Closing?

Only debts secured by the property you are selling. A first mortgage, a second mortgage or a home equity line recorded against the relinquished property can be paid off at closing, and that payoff is treated as debt relief within the exchange. Paying anything else from the sale, such as a credit card, a personal loan, a car loan or a mortgage on a different property, is generally treated as if you received the cash and spent it. That cash is boot, and boot is taxable.

Why does it matter which debt gets paid?

In a 1031 exchange, the goal is that you never have access to the sale proceeds. Your Qualified Intermediary holds the money and uses it to buy the replacement property. If you could direct part of the proceeds to your own bills, you would be enjoying the benefit of that cash, even if it never touched your bank account.

Debt that is secured by the property you are selling is different. The buyer cannot take clean title until those liens are released, so paying them is part of transferring the property. The tax rules treat that payoff as relief from a liability, which then has to be matched on the replacement side, either with new debt or with added cash.

Which payoffs are generally treated as part of the exchange?

These are usually handled within the exchange because they are recorded against the relinquished property:

• ›The first mortgage on the property you are selling
• ›A second mortgage or home equity line secured by that same property
• ›Property tax owed on that property and paid through closing
• ›Other liens recorded against that property, though unusual liens are worth raising with your CPA

Ordinary selling expenses, such as the commission, title and escrow fees, are a separate category. Many are treated as exchange expenses, but some settlement charges are not, so the full settlement statement should be reviewed before it is signed.

Which payoffs generally create boot?

These are typically treated as cash to you, because the debt is not tied to the property being sold:

• ›Credit cards and unsecured personal loans
• ›Car loans or business equipment loans
• ›A mortgage or line of credit on your home or on another rental
• ›Personal obligations such as taxes owed for a prior year, settlements or loans from family

It does not matter that the payment goes straight from the closing agent to the creditor. The question is whose obligation it satisfies and whether it is secured by the property being exchanged.

An illustrative example

Here is a simplified, illustrative example. The figures are not a projection and ignore closing costs.

An owner sells a rental building for $900,000. At closing, the building carries a $300,000 first mortgage and a $40,000 home equity line, both recorded against it. The owner also asks the closing agent to pay a $25,000 personal line of credit from the proceeds.

• ›The $300,000 mortgage and the $40,000 line add up to $340,000 of debt relief. That is part of the exchange, and the owner will need at least $340,000 of new debt or added cash on the replacement property to avoid mortgage boot.
• ›The $25,000 personal line is not secured by the building. Paying it from the sale is generally treated as the owner receiving $25,000 in cash. That is cash boot, taxable to the extent of the gain.
• ›The Qualified Intermediary receives $900,000 minus $340,000 minus $25,000, which is $535,000, instead of $560,000.

If the owner had paid the $25,000 line from other savings before closing, the intermediary would have received the full $560,000, and none of the payoffs would have produced cash boot. The owner would still need to replace the $340,000 of debt relief and reinvest the full $560,000 to defer all of the gain.

What about a loan taken out just before the sale?

Some owners draw on a line of credit secured by the property shortly before selling, use the cash personally, and then let the line be paid off at closing. On paper, the payoff looks like ordinary debt relief. In substance, it can look like taking cash out of the exchange in advance.

How this is treated depends on timing, purpose and facts that an examiner may look at closely. Borrowing that happens well before the sale, for reasons unrelated to it, is viewed differently from borrowing in the weeks before closing. If you are considering any new borrowing against a property you plan to exchange, talk to your CPA before you draw on it.

What are the alternatives if you need to clear other debts?

Owners who want to pay down personal or unrelated debt as part of a sale usually look at one of these routes, with their advisers:

• ›Pay it from other funds. Using savings or income outside the sale keeps the exchange proceeds intact.
• ›Take a deliberate partial exchange. Some owners accept that a portion of the sale will be taxable boot and use that portion for other purposes. The tax on that portion is the cost of the choice.
• ›Address it after the exchange. Some owners later refinance a replacement property once the exchange is complete. Refinancing carries its own considerations, and the timing and purpose should be reviewed with your CPA before relying on it.

None of these is right for everyone. The point is to choose on purpose rather than discover the result on the settlement statement.

How do you catch this before closing?

The payoff lines on the settlement statement are where this shows up. Before the closing date, ask the closing agent for a draft and look at every payoff and every disbursement other than the transfer to your Qualified Intermediary. For each payoff, confirm that the loan is recorded against the property being sold. If anything else appears, stop and ask why it is there.

It also helps to tell your Qualified Intermediary early about every loan on the property, including lines of credit that may have a zero balance, so the payoff letters requested at closing match what is actually owed.

Bringing it together

Liens on the property you are selling can be paid at closing as part of the exchange, and that debt relief then has to be replaced. Personal and unrelated debts are a different matter, because paying them from the sale is generally treated as taking cash. Review the draft settlement statement line by line, and ask your CPA and Qualified Intermediary about any payoff you are unsure of before you sign.