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.
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 You might like to consider that the $100,000 you want to keep from your sale was a portion of the down payment you originally made to acquire your relinquished property, but the IRS will see it as part of the capital gains earned as a result of the sale.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 partial exchange in order to reduce the overall percentage of real estate in your investment portfolio.
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.
While the information provided above has been researched and is thought to be reasonable and accurate, it’s important to talk with your tax professional regarding your personal tax situation.