Selling an investment property can net you a significant financial windfall – and also generate some stiff tax consequences for highly appreciated real estate assets.
Completing a 1031 exchange allows you to defer the capital gains tax liability from your sale, but oftentimes, investors want to set aside a portion of their sales proceeds to boost their liquidity. If you want to take some cash out of your relinquished property, you don’t have to roll over the entire sales proceeds into a like-kind replacement property to still enjoy the benefits that come with completing a 1031 exchange. You can do a partial 1031 exchange, which is also known as a split exchange. This tax strategy allows you to exchange a portion of your sales proceeds and keep some cash for yourself – but you’ll have to pay taxes on any money that’s not reinvested into the replacement asset.
This strategy also works for 1031 exchange investors who cannot find suitable replacement properties that align in value. In a 1031 exchange, properties must be of equal or greater value to fully defer all capital gains tax liabilities – you cannot use the exchange process to improve your financial standing or reduce leverage. If you sold an investment property for $1 million but identified a replacement property that was only worth $800,000, you could keep the $200,000, but you would have to pay capital gains (and depreciation recapture) taxes on that amount. Any funds that are not reinvested into a partial like-kind exchange is called “boot.” Capital gains taxes depend on your income and filing status, but it would be 0, 15, or 20 percent if you held the original investment property for longer than a year. Short-term capital gains, meanwhile, are taxed at your nominal tax rate.
It’s important to note that boot can take different forms. Cash boot is cash received from the sale of the relinquished property, while mortgage boot comes from a reduction in mortgage liabilities on the replacement property versus what was owed on the relinquished property. Boot in either form is taxable, and the tax rate you pay depends on how the boot was generated.
How to Complete a Partial Like-Kind Exchange
If you plan on executing a partial 1031 exchange, you’ll have to follow the same rules and restrictions that come with a standard 1031 exchange transaction. If you know the exact amount needed for acquisition of the replacement property, you may request that a certain dollar amount is distributed to you directly at the closing of the relinquished property's sale.
Usually, the exact amount of equity needed for the purchase of the replacement property is unknown at this stage. One solution is to have the qualified intermediary (QI) hold all of the proceeds from the property sale, and distribute the excess cash from the exchange account after the equity requirements for the replacement property have been determined. However, you will have to wait to receive the excess funds after you close on the replacement property. Once the QI releases the excess funds into your control, you will owe capital gains taxes on the amount.
A partial exchange is a bit more complicated than a standard exchange, so selecting your “exchange team” is important before beginning the sale process. Consult your accountant early on to understand the tax consequences of a partial exchange. You may have unrelated tax implications, such as income tax losses, that could be offset and could influence your exchange decisions.
Selecting an experienced QI who has completed partial like-kind exchanges also plays a critical role because your entire exchange could be disqualified if you don’t follow the Internal Revenue Service rules to the letter. Choosing an experienced QI can make a big difference when it comes to making your partial exchange a seamless process.
Is A Partial Exchange Right For You?
As always, determining whether a partial exchange is right for you depends on your specific situation. Some of the main factors to consider include your need for immediate cash and the subsequent tax consequences, which are dependent on the relinquished property’s cost basis and how much you’ve claimed in depreciation during the time you held the asset.
Let’s look at a couple of examples to get a better understanding of how boot is created. Say you sell a property with no mortgage and realize a net profit of $350,000. You find a replacement property that is worth $300,000, and since you have $50,000 that can’t be reinvested in the replacement property, you’ll be taxed on it at the capital gains tax rates listed above.
Another example: You sell a property for $400,000, but it has a $200,000 mortgage. You reinvest the $400,000 on a replacement property, but you only have a $175,000 mortgage. There’s a $25,000 difference in the two mortgages, which is the amount of mortgage boot that’s taxable.
What Are The Pros of a Partial 1031 Exchange?
Below are two reasons why you might consider doing a partial 1031 exchange:
- You need funds from the exchange. If you need funds from your 1031 exchange, then a partial exchange can help increase your liquidity. The money can be used for anything — vacation, acquiring other property, medical needs, etc.
- Reduce leverage on replacement property. You may want to remove some leverage/debt on your replacement property. As an example, your relinquished property sells for $300,000 and has a $20,000 mortgage. You can 1031 exchange the $300,000 into the replacement property, generating a tax bill on the $20,000 boot.
What Are The Cons of a Partial 1031 Exchange?
If the amount of boot is equal to or greater than the capital gains realized from the relinquished property, there’s likely no benefit in doing a 1031 exchange. It will depend on your basis and depreciation. You’ll want to consult a tax professional for clarification, especially since boot can be taxed at different rates depending on how it was created. Additionally, if the boot is large enough, the partial exchange liability could be equal to or come close to the tax liability of just divesting the property in a straight sale.
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.
Hypothetical examples shown are for illustrative purposes only.
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.