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Exchanges Of Mortgaged Property

In the straight equity for equity exchange of properties that are of like kind and held for investment or business use, there is no income tax liability at all. But there can be a tax liability when the exchange involves mortgaged property unless the right, tax-saving technique is used.

Example: You own an investment property worth $500,000, which is subject to a $100,000 mortgage. Your cost basis in the property is $420,000.

You exchange the property for another worth $750,000, which is subject to a $400,000 mortgage. Because you are trading your $400,000 equity for an equity of $350,000, you will receive $50,000 in cash to even off the equities. The other owner has agreed to pay that amount.

Tax Result: You must pay federal tax on the cash you receive. (Cash boot.)

Solution: Instead of taking the $50,000 cash to even the equity, have the other owner of the property being acquired use the money to reduce his mortgage by $50,000 before the closing of the transaction. That evens off the equities, so you receive no cash and owe no tax.

Here is another thought. It is always a tax-free event when you refinance a property that you already own. Either owner can receive tax-free cash by refinancing an owned property either before or after this transaction, but not as part of the exchange.

For instance, you can refinance the second property after closing the exchange transaction if you need cash.