When performed successfully, the 1031 exchange process can help you trade your real estate property into another one of greater or equal value and allow you to potentially defer capital gains and depreciation recapture taxes.
But you might want to obtain that higher-quality replacement property AND keep some money. You can still use like-kind exchange methods to do this. This is known as a partial 1031 exchange or a split exchange. This strategy means you can exchange a portion of the sales proceeds from your relinquished property, potentially leaving you with some leftover cash.
If you decide on this type of action, there are partial 1031 exchange rules to consider for a successful trade.
Defining the Partial 1031 Exchange
If you want to potentially defer all of the taxes owed on the sale of real estate, you might decide on a traditional 1031 exchange. But you don’t have to plow all the proceeds from selling your relinquished property into the replacement property. With the partial 1031 exchange, you could cash out part of the proceeds from your relinquished property and take it as cash. The official term here is “boot.”
According to the 1031 exchange rules, any difference between net sales proceeds you receive from the sale of the replacement property and the total amount you invest in a replacement property is considered a partial exchange.
The likely upside to this is increased liquidity for you. But the downside is that you’ll owe capital gains and depreciation recapture taxes on that boot. Be sure to account for those payments if you consider a split-like-kind exchange.
For example, you might sell your replacement property for $350,000 and hold back $50,000 as boot. In this case, you’d reinvest the $300,000 in a replacement property and keep the remainder as cash.
Rules to Consider
The rules involving a partial 1031 exchange are identical to those connected with a standard exchange. Specifically:
Like-kind properties. You still exchange and receive real estate used solely for investment or business purposes. Like-kind properties can also be traded across state lines or asset classes.
Timing. Once you sell your relinquished property, you have 45 days to identify a replacement property of greater or equal value – and 180 days to close on it.
IRS reporting. Like the standard 1031 exchange, you must report a partial exchange to the IRS using Form 8824 – “Like-Kind Exchanges.” This must be filed with your tax return for the year the exchange occurred.
When Partial Exchanges Make Sense
Receiving part of your 1031 exchange proceeds as boot can offer certain advantages. It can provide liquidity to help with portfolio diversification or could generate cash to pay down debt or other expenses. However, it’s essential to understand the taxes you might owe through the process and how much to defer through a partial exchange.
Because partial 1031 exchanges are complex with many considerations, consult with a tax professional before proceeding.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.
