Learn about what qualifies as an investment property in a 1031 exchange and what you can and can't do with your 1031 properties.
Understanding the Five Basic Rules of a 1031 Exchange: Net Selling Price
Learn what net selling price is, how it's calculated, and what happens if you can't find a property with enough value in your 1031 exchange.
What is Net Selling Price?
Net Selling Price (NSP) is the contract sale price of a property minus some of the standard closing costs. In a 1031 exchange, you must buy property equal to or greater than the NSP of the relinquished property. Doing this defers all capital gains. If an investor does not buy a replacement property of enough value, they incur a tax liability.
What if I Don’t Find Property of Equal or Greater Value?
Maximizing tax deferral requires the rolling forward of the Net Selling Price. But, that doesn’t mean you have to use all the funds. If you would like to roll a part of the NSP into a new property and keep a part for yourself, you can do that! This is a partial 1031 exchange. In this case, proceeds rolled forward into a replacement property are tax-sheltered. Also, the proceeds kept out of the exchange are subject to any liable taxation. The key with a partial exchange is to ensure your qualified intermediary (QI) knows that you would like to keep a certain percentage of the proceeds before closing on the relinquished property.
You may have cash left over after the QI acquires the replacement property. If so, the intermediary will pay it to you at the end of the 180 days. That cash—known as “boot”—will be taxed as partial sales proceeds from the sale of your property. It’s generally taxed as a capital gain.
How Do I Calculate Net Selling Price?
It is important to know the difference between the profit made from the sold property and the NSP. These numbers are commonly misunderstood. It is often mistaken that only the profit rolls into a new property purchase for full tax deferral. For example, you bought an investment property for $100,000 and sell it for $150,000. The NSP is $150,000. NSP is not the $50,000 profit on the property. To defer all taxes, you need to push $150,000 to the replacement property in the exchange.
One of the main ways people get into trouble with this exchange is by failing to consider loans. You must consider mortgage loans or other debt on the relinquished property and any debt on the replacement property. If you don’t receive cash back but your liability goes down, that too will be treated as income to you just like cash. To put this into perspective, suppose you had a mortgage of $1 million on the old property. But, your mortgage on the new property you receive in the exchange is only $900,000. You have $100,000 of gain that is also classified as “boot,” and it will be taxed.
To start exchanging or to learn more about 1031 exchanges, call Midland 1031 at (239) 333-1031 or visit our website.
Written by Sam Tennant
Midland 1031 Associate, Midland IRA, Inc.