Related Post: 1031 Exchanges – Back to the Basics
While 1031 exchanges allow for full tax deferral, there are situations where investors may choose or need to do a partial exchange. Some investors may be willing to pay a portion of the capital gains taxes in exchange for a portion of the proceeds.
An investor may need cash now to pay medical bills or want to take a nice vacation. Whatever the reason, a partial 1031 exchange is an option, and this article will explain what that means and the tax implications.
What is a Partial 1031 Exchange?
Through a partial 1031 exchange, a portion of the sale proceeds can be cashed out for immediate use, and the remainder of the proceeds can be reinvested into another property. 1031 exchange rules do not limit you from completing an exchange if you do not intend to reinvest the entirety of your sale proceeds.
In a partial 1031 exchange, the cash amount you decide to keep is considered “boot”, and this boot triggers the tax. 1031 exchange boot can be defined as “additional value received.” In other words, you used your exchange funds and acquired something of value that did not qualify in terms of the 1031 exchange, for example:
- You earned and kept cash
- You reduced your mortgage amount
- You used the exchange funds to purchase non-like-kind property
With a partial exchange, the taxable boot has been anticipated and is acceptable, though in most cases, 1031 exchange boot is an unpleasant surprise.
How IRS Rules Apply to Partial Exchanges
A partial 1031 exchange follows all the same rules as a standard 1031 exchange. These rules include:
- Like-kind property: Your replacement property must be considered “like-kind,” meaning it must be property of the same nature or character as your relinquished property.
- Timing: After the relinquished property sale, you have 45 days to identify a replacement property and 180 days to purchase it.
- Cash Boot: After your partial exchange, you’ll have cash left over, which the IRS considers to be the remainder of the earned capital gains. This is called boot, and you will be taxed on it.
Maximizing Tax Deferral: Deciding How Much to Reinvest
In a standard 1031 exchange, you need to reinvest 100% of the proceeds from the sale of your relinquished property to defer all capital gains taxes. In a partial 1031 exchange, you can decide to keep a portion of the proceeds. This boot amount is taxable, while the money you reinvest is not.
The amount you reinvest in your 1031 exchange depends on how much money you need.
For example…
- If you sell a property for $400,000 and need $50,000 for college tuition
- You could reinvest $350,000
- And put the remaining $50,000 toward the tuition
- Keep in mind that the $50,000 will be taxed
It’s possible that you may not find a good replacement property with the same or greater value as the one you relinquished. Rather than compromising on the quality of your replacement property to meet full reinvestment requirements, you may choose to acquire a property that better aligns with your goals—even if it’s of lesser value. In this case, you would pay capital gains taxes only on the remaining proceeds, known as boot.
- For example, suppose you sell a property for $500,000 and find a high-quality replacement property that costs $450,000. Rather than purchasing a less suitable property just to meet the full reinvestment requirement, you opt to acquire the $450,000 property. In doing so, you retain $50,000 in remaining proceeds—known as boot—which would be subject to capital gains tax. This allows you to invest in a property that better meets your objectives while understanding and accepting the associated tax on the portion not reinvested.
Investors may opt for a partial exchange for a variety of strategic reasons—such as accessing liquidity, adapting to changing investment goals, or encountering limited replacement property options. While this approach results in a taxable boot, it can offer added flexibility when full reinvestment isn’t the right fit.
What is the Basis of a Partial 1031 Exchange?
Your basis is the price you pay to acquire a property, including acquisition costs like legal fees. In a partial 1031 exchange, the cost basis of the relinquished property rolls over to your replacement investment property.
A 1031 exchange requires that the equity amount in your replacement property remains equal to or becomes greater than the equity amount that you had in the relinquished property.
You might like to consider that the $100,000 you want to keep from your sale was a portion of the down payment you originally made to acquire your relinquished property, but the IRS will see it as part of the capital gains earned as a result of the sale. The basis rules are the same for full and partial exchanges, but the amount of basis transferred is affected by the amount of reinvested proceeds.
Partial 1031 exchanges have benefits for those investors seeking to liquidate cash; however, there are other strategic reasons investors may consider a partial exchange.
Examples of Partial 1031 Exchange Applications
Example #1
Partial exchanges may help you offset investment losses with gains from your real estate investment.
- Tax Impact: In this example, you have $500,000 invested in a multi-family property, and the anticipated rent fell short in the last year of ownership. You were planning on using $15,000 of that rent to cover a child’s wedding costs. Now, you may reinvest $470,000 into a new property and use the remaining $30,000 to cover the wedding costs plus the anticipated tax consequences.
Example #2
Partial exchanges can provide a way to reallocate investment funds. You can liquidate some of your real estate holdings through a 1031 exchange with partial interest in order to reduce the overall percentage of real estate in your investment portfolio.
- Tax Impact: In this example, you sell a commercial property for $900,000. After subtracting your adjusted basis of $400,000, you realize a gain of $500,000. You decide to use $700,000 of the proceeds to purchase a replacement property through a 1031 exchange, but you retain $200,000 in cash (boot) to diversify your portfolio by investing in stocks or bonds.
Example #3
In a partial 1031 exchange, investors reinvest only a portion of their sales proceeds into replacement property, resulting in some taxable boot. When full reinvestment into a single property isn’t feasible, one option is to diversify by acquiring fractional interests in multiple properties. Delaware Statutory Trusts (DSTs) are a common vehicle for this strategy, allowing investors to purchase beneficial interests in institutional-grade real estate—often with lower minimum investments and no management responsibilities.
- Tax Impact: In this example, an investor sells a rental property for $1,200,000. After searching, they found a direct replacement property for $1,000,000, but nothing else suitable to make up the remaining $200,000 needed to fully defer taxes. To avoid being taxed on the leftover funds, they invest the remaining $200,000 into a DST, which allows them to acquire a fractional interest in a professionally managed commercial real estate portfolio. This is one example of how investors use multiple properties to avoid boot entirely. If you’re asking, can you buy multiple properties in a 1031 exchange? Yes, and doing so is often a deliberate strategy to meet the equal-or-greater value requirement without leaving proceeds on the table.
Making the Partial Exchange Decision: Your Next Step
A partial exchange may help you balance your portfolio, access needed cash, or navigate a poor buyer’s market. The best next step is proper planning and partnering with 1031 exchange experts.
Register for a free account with 1031 Crowdfunding to access exclusive 1031 exchange listings, resources, and backup options like Delaware Statutory Trusts (DSTs). DSTs can help you reinvest any remaining proceeds down to the penny—minimizing or even eliminating taxable boot—while keeping your exchange fully compliant. You’ll also gain access to our team of 1031 exchange specialists for personalized guidance.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC
