All You Need to Know About a Partial 1031 Exchange
**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**
There are several good reasons to complete a quite-permissible partial 1031 Exchange.
For sure there are tradeoffs you’ll want to weigh when considering one. You’ll find help here for making those calculations both in terms of dollars and personal goals.
We’ll start by explaining what it is and then outline the mechanics of partial 1031 Exchanges.
What Is a Partial 1031 Exchange?
A partial exchange occurs when relinquished property proceeds are not all expended on replacement(s). That portion of those exchange proceeds not reinvested is called cash boot. It’s subject to capital gains and depreciation recapture taxes.
If done intentionally with planning, that may be a good option. A 1031 Exchange doesn’t need to be an all-or-nothing proposition. You can opt to cash out some proceeds from your relinquished property’s sale. At the same time – when you reinvest the remaining proceeds – capital gain recognition and other tax exposures are deferred.
How Can You Do a Partial 1031 Exchange?
A partial 1031 Exchange follows all regular exchanges’ steps and restrictions. Then in accordance with the exchange agreement – worked out in advance with your 1031 exchange accommodator (Qualified Intermediary or QI) – you typically follow one of two paths.
Specify the Cash Out Amount
Knowing the exact cost of the replacement(s), you can specify the amount to be distributed directly to you on the relinquished property’s closing. That is the remainder when replacement(s) costs are subtracted from relinquished property proceeds. In other words the cash out amount.
Caution: When the actual distribution is made depends on provisions of your exchange agreement. When engaging your intermediary, you’ll likely want the agreement to stipulate such funds be released promptly.
QIs may consent to have immediate release written into the agreement. Otherwise they could hold your cash the full 180-day exchange completion period (all the while with interest accruing to them).
You or an advisor may want to select among the best 1031 exchange companies having long-term success dealing with this and the many other complex issues involved.
Wait for the Receipt
Typically however it’s unknown at the time of the relinquished property sale exactly how much the replacement(s) will cost. Per irrevocable 1031 Exchange requirements, your QI holds all relinquished property.
Once replacement(s) costs are determined, cash out amounts are determined. However, you’ll likely have to await receipt pending closing on the replacement(s). Once the QI releases the excess funds into your control, you’ll have tax gain recognition.
Partial 1031 Exchange Example
Say you’re selling relinquished rental property for $500,000 while wanting $50,000 in cash. Your exchange agreement specifies only 90% of the rental proceeds are to be included in the exchange. The remaining 10% will remain outside the exchange.
There are two parts then to the sale: the $450,000 exchanged portion and the cash out of $50,000. The exchange agreement must clearly state that only 90% of the sale proceeds are to be included in the exchange. Further, it’s made clear the remaining 10% balance or $50,000 is to be excluded from the exchange.
Any QI failure to properly record cash out terms could cause the IRS to disallow the entire exchange. Be mindful that it’s your responsibility to ensure documents are correctly prepared to show the split-sale terms accurately.
Tax Consequences of a Partial 1031 Exchange
In the previous example, you’ll be unable to defer from taxation $50,000 of the $500,000 in sale proceeds. That portion not reinvested produces cash boot subject to capital gains and depreciation recapture taxes.
After all, legislative intent here is for the 1031 Exchange to defer not forgive taxes. Now being removed from that deferral process, cash out funds won’t escape taxation.
Note: As a general rule, an Exchanger who reinvests less than 50 percent of sale proceeds in replacement(s) creates taxable boot likely zeroing out all tax deferrals. While such an exchange can proceed, there’s no purpose when 1031 exchange costs and deferral amounts net each other out.
Pros and Cons of Partial 1031 Exchanges
Which Is It to Be: Cash or No Gain Recognition?
Whether a partial exchange is the best answer depends on facts and circumstances relevant in your situation. Finally, such considerations usually require expert analysis.
Two often prominent but opposing factors are:
- immediate cash needs weighed against
- relinquished property’s cost basis and existing accumulated depreciation.
The focus being: relative need for cash weighed against boot resulting in gain recognition. Both being high augurs well for an exchange. That is, cash needs are great and a high-cost basis means minimal gain recognition.
The reverse would of course make an exchange less desirable. Less in tax deferrals without critical cash needs. Also, in both cases don’t forget that depreciation recapture taxes could potentially be costly.
4 Benefits of a Partial 1031 Exchange
1. Cashing Out
As discussed, if you need cash from your 1031 Exchange, a partial exchange will meet that need. Use of the cash is unrestricted but will be taxed at ordinary income tax rates.
2. Removing Mortgage Debt from Replacement(s) Without Mortgage Boot
You can remove mortgage debt from replacement(s) yet avoid mortgage boot. This is possible even when replacement(s) carry less mortgage debt than relinquished property. Replacing debt can give you the same debt value in replacements as relinquished properties.
Say that you are exchanging a rental carrying a $1M mortgage. If the replacement has a $900,000 mortgage, you’ve constructively received $100,000 in taxable income. Still you have the option to replace debt and avoid boot. You can replace that $100,000 debt imbalance with:
- cash if you want to maintain the same amount of debt,
- an ordinary mortgage or private loan, or
- a seller financed loan.
In any combination these methods can be used to replace debt value. With your original property carrying that $1M mortgage, e.g., you can take out a $900,000 mortgage on the replacement plus borrow $100,000 in a manner just outlined. As long as the value of the original debt is covered, your investment will be fully tax-deferred.
3. Improving Your Investment Portfolio
In the same tax year, you can elect to sell off any losers in your portfolio to offset the taxable boot the partial 1031 Exchange created.
4. Offsetting Current Year Taxable Boot
From previous tax years – if other transactions have left you with a loss carrying-forward – it can be used to offset current year taxable boot.
2 Downsides of a Partial 1031 Exchange
1. Taxable Boot
Maximizing tax deferral opportunities are usually lost. If taxable boot is large enough, tax liabilities and exchange costs may exceed any tax deferral benefits.
2. Strict Deadlines
1031 exchange property identification and exchange periods involved are relatively short and strictly enforced by the IRS. All tax deferrals are lost if these deadlines are missed. From the date relinquished property(ies) are sold, replacement(s):
- must be identified within 45 days and
- titles to them received within 180 days.
Pressured to meet these deadlines, selecting replacement(s) may be rushed and ultimately not meet expectations.
How to Keep Your 1031 Exchange Legal and Safe?
Unless you are conducting a simultaneous exchange that doesn’t involve boot, you must use services of a qualified intermediary.
A professional, competent, and experienced 1031 exchange company with income tax experts on the team will advise you on the options you have to minimize your boot while getting the most of your relinquished property value.
They will ensure that the procedure is completed legally, in compliance with all IRS rules.
PropertyCashin is an all-in-one platform for commercial real estate investors that maintains relationships with top-rated 1031 exchange firms in all locations of the USA.
Get connected with the best professionals and have your exchange processed safely and effectively by filling out the form below.