Often, 1031 investors would like to set aside a portion of the money from their property sale. Perhaps they have college tuition or an upcoming wedding to consider. This begs the question: Is it possible to keep a portion of a property sale’s proceeds while still deferring the majority of taxes with a 1031 exchange?
In a word: absolutely. You are not required to reinvest 100 percent of your sales proceeds. When you don't exchange all your proceeds, it's called a “partial 1031 exchange.” The portion of the exchange proceeds that are not reinvested is called “boot,” and are subject to capital gains and depreciation recapture taxes.
It’s important to note that boot can take different forms. Cash boot is actual cash received from the sale of the relinquished property that is not reinvested. Mortgage boot is a reduction in mortgage liabilities on the replacement property, compared to what was owed against the relinquished property. Boot in either form is taxable.
To execute a partial 1031 exchange, follow all the same rules and restrictions as a standard 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.
Since a partial exchange is a bit more technical than a standard exchange, selecting your “deal team” is important. 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 which could influence your decision.
An experienced QI also plays a critical role because not following the rules exactly could result in disqualifying your entire exchange, while an experienced and competent QI can make a difference in making your partial exchange a seamless process.
1031 exchange investing doesn't have to be difficult. That’s why we’ve created an investor guide to 1031 exchange investing. It tackles the art and science of completing your exchange, and the pitfalls to avoid. What is a 1031 Exchange? features helpful charts, diagrams, timelines, and more. Get your copy today.