Discussing Partial 1031 Exchanges
I'm planning to sell an investment property and purchase a new investment property. I'd like to defer capital gains through a 1031 exchange, but I also need to keep some of the cash from the sale. I wish I could do both.
It's a common misunderstanding that you cannot keep any of the proceeds from the sale of a relinquished property if you plan to complete a 1031 exchange. This is true if you want to defer 100% of the taxes owed after the sale, but, if you are willing to pay a portion of the capital gains taxes, then you can keep a portion of the proceeds.
Consider the investor who needs cash now. It might be to pay medical bills; it might be that a nice vacation is long past due. Whatever the case, rather than refinance, take out a new loan, withdraw from a 401K or find cash elsewhere, the investor decides it's a profitable time to sell a rental property and to obtain the needed funds from the sale. A portion of the proceeds can be cashed out for immediate use, and the remainder of the proceeds can be reinvested into another property through a partial 1031 exchange. 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. In this case, the taxable boot has been anticipated and is acceptable; though in most cases 1031 exchange boot is an unpleasant surprise or an unavoidable reality. If you're dealing with unwanted boot, let us refer you to some suggested ways to put your boot to work.
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 the terms of the 1031 exchange; you pocketed cash, you reduced your mortgage amount, you used exchange funds to purchase non-like-kind property, etc. Though incurring boot will not disqualify your 1031 exchange, the value of your boot will be taxed.
What are the partial 1031 exchange requirements from the IRS?
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.
• Value: The replacement property's value must be the same as or more than the relinquished property's value.
• Debt: The debt on the replacement property must be the same as the debt on the relinquished property.
• Boot: If you have cash left over from the sale of the relinquished property after buying the replacement, the IRS considers the remainder earned capital gains and will tax you on it.
How much should I reinvest in a 1031 exchange?
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.
A partial 1031 exchange may make sense if you need some of the money from the property sale. For example, if you sell a property for $400,000 and need $50,000 for college tuition, you could buy a property for $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. Instead of buying something subpar to satisfy the investment requirement, you can purchase a more desirable property for less and pay taxes on the boot.
A partial 1031 exchange may also make sense if you want to eliminate your debt. For example, if you sell a property for $500,000 with a mortgage balance of $50,000, you could buy a replacement property for $400,000 and be taxed on the $50,000 boot to make the purchase free and clear.
What is the basis of a partial 1031 exchange?
Your basis is the price you pay to acquire a property, including acquisitions costs like legal fees. In a partial 1031 exchange, the cost basis of the relinquished property rolls over to your replacement property.
So I understand that I can't keep the profit from the sale of my investment property, but couldn't I cash out my equity without having to pay taxes?
Unfortunately, no. A 1031 exchange requires that your 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.
Partial 1031 exchanges have benefits for those investors seeking to liquidate cash; however, there are other strategic reasons investors may consider a partial exchange:
• Partial exchanges may help you offset investment losses with gains from your real estate investment.
• Partial exchanges can provide a way to re-allocate 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.
• Partial 1031 exchanges allow you to acquire a fractional interest in additional replacement properties when you can't find one that meets or exceeds the value of your relinquished property. A Delaware Statutory Trust (DST) is a popular 1031 exchange vehicle with a partial ownership structure that allows taxpayers to receive small fractional interests in real estate.
If a partial 1031 exchange is not your intention, here is a reminder of some general rules to keep in mind if you want to make sure to defer 100% of the capital gains taxes through a 1031 exchange:
• Buy a replacement property that is equal to or greater in value than the net selling price of your relinquished property. Trade across or up, never down.
• The amount of the mortgage you take out to finance your replacement property should always be equal to or greater than the amount owed on the relinquished property (or elect to replace an amount of debt with an additional cash contribution).
• The amount of equity held on the replacement property should always be equal to or greater than the amount of equity held on the relinquished property.
Whatever reason you may have to complete a partial 1031 exchange, we recommend that you discuss your options with a tax advisor prior to completing any real estate transactions to ensure you fully understand the amount of taxes that will be owed.
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