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.
Is A Partial Exchange Right For You?
As always, whether a partial exchange is right for you will depend on your specific situation. Some of the main factors will include a need for immediate cash and the tax consequences, which are dependent on the relinquished property’s cost basis and depreciation.
Let’s look at a couple of examples to get a better understanding of how a boot is created. You sell a property with no mortgage and net $350,000. The replacement property is worth $300,000. Because the $50,000 can’t be invested in the replacement property, you’ll be taxed on it at the ordinary tax rate.
This time you sell a property for $400,000 but it has a $200,000 mortgage. You decide to reinvest the $400,000 on a replacement property with a $175,000 mortgage. There’s a $25,000 difference in the two mortgages, which you’ll receive a tax bill for.
What Are The Pros of a Partial 1031 Exchange?
Below are two reasons why you might consider doing a partial 1031 exchange.
Need funds from the exchange — if you have a need for funds from your 1031 exchange, then a partial exchange can meet that need. The money can be for anything — vacation, other property, medical needs, etc. Funds coming out of the exchange will be taxed at your ordinary income tax rate.
Reduce leverage on replacement property — you may want to remove leverage/debt from the 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 boot is equal to or greater than the capital from the relinquished property, there’s likely no benefit from doing an exchange. It will depend on your basis and depreciation. You’ll want to consult a tax professional for clarification. Additionally, if the boot is large enough, the partial exchange liability could be equal to or come close to the tax liability of doing no exchange at all.
What is a 1031 Exchange
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