When you’re selling a property in a 1031 exchange, you need to move all of your equity into the new replacement property in order to defer all of your capital gains taxes. However, you are allowed to pay off debt associated with the relinquished property. So how do you handle unsecured debt in a 1031 exchange transaction?
Oftentimes people have recorded mortgages or deeds of trust against the old relinquished property and that’s clearly associated with the property. But what about unsecured debts? What if you’d borrowed $60,000 from you Aunt Matilda and you just had a promissory note or I-owe-you? Is that associated with the property?
One way to tie the debt to the property so that it’s associated with the sold property is to have the note specify that if the subject relinquished property is ever sold the note has to be paid off at the time of closing.
Contractually Tie the Debt to the Sale
Furthermore, you can state in the purchase agreement with your buyer that as a material and substantial condition of this sale, the debt owed to Aunt Matilda must be paid at the time of closing. So you can contractually tie the debt to the sold relinquished property. The regulations state that you can offset the debt relief on the old relinquished property by taking out new debt on the replacement property. That means you can pay off the debts on the old relinquished property without recognizing any gain, provided you offset that debt relief with new debt or new cash in on the replacement side.
The trick is to plan early. Make sure your debts are recorded against the property or that you’re contractually required to dispose of that debt in conjunction with the sale of your old relinquished property.