What is a Partial 1031 Exchange?

Selling an investment property can net you a significant financial windfall – and also generate stiff tax consequences for highly appreciated real estate assets. 

Completing a 1031 exchange allows you to defer capital gains tax liability from your sale. However, 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 all of the 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, 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. However, you’ll have to pay taxes on any money that’s not reinvested in 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 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. Mortgage boot comes from failing to replace the value of debt that was owed on the relinquished property. This value can be replaced by picking up equal or greater debt on the replacement property, or bringing cash to closing. 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 as a standard 1031 exchange transaction. I would just focus on the fact that you will need to follow the same rules as a full 1031 exchange to defer taxes on the partial exchange - 45-day deadline, 180-deadline, cannot take receipt of funds.

Then, once a replacement property has been identified, the QI can disburse the excess cash to you. Once the QI releases the excess funds into your control, you will owe capital gains taxes on the amount. 

A partial exchange is 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 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. These consequences 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 understand how boot is created. Say you sell a property with no mortgage and realize a $350,000 net profit. You find a replacement property that is worth $300,000. Since you have $50,000 that can’t be reinvested in the replacement property, you’ll be taxed on it at your capital gains tax rates listed above. 

Another example: Suppose you sell a property for $400,000, but it has a $200,000 mortgage. You reinvest the $200,000 of equity into a replacement property, but only use a $175,000 mortgage to acquire a total property value of $375,000. There is a $25,000 difference in the two mortgages, and thus the property value sold vs. acquired, which is the amount of boot that's taxable.

What Are The Pros of a Partial 1031 Exchange?  

Below are two reasons to consider a partial 1031 exchange: 

• You need funds from the exchange. If you need funds from your 1031 exchange, a partial exchange can increase your liquidity. The money can be used for anything — vacation, acquiring other property, medical needs, etc. 

• Reduce leverage on the replacement property. You may want to remove some leverage/debt on your replacement property. You can 1031 exchange the $280,000 of equity into the replacement property with no debt, generating a tax bill on the $20,000 of 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 depends 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.