There will be consequences. Often, real estate investors doing a 1031 exchange would love to set outside a portion from the sale of their relinquished property. Perhaps, they need funds for their business, children’s college tuition, or a pending personal debt. Now, this leads us to the question, is it still possible to keep a portion of your relinquished property sale proceeds and still defer the payment of taxes with a 1031 exchange?
In a short answer; Yes. You do not need to reinvest 100 percent of the proceeds from the sale of your relinquished property. When you do decide to keep a certain portion back, you are doing what is called a partial 1031 exchange. And the portion of the realized sale proceeds you decide to keep back is known as boot and it is subject to capital gains and depreciation recapture taxes. Please note that boot can take two major forms—cash boot and mortgage boot.
How Does a Partial Exchange Work
To perform a partial 1031 exchange, you will need to adhere to all the IRS stipulated rules and regulations guiding a typical exchange process. However, if you have decided on the price of one of your replacement property, you may request to receive a portion of the money from the sale at the closing of the sale or at any time thereafter.
Usually, at the point of closing on the sale of your relinquished property, the exact amount needed to purchase the replacement property is mostly unknown. A good solution is having the escrow hold the realized sale proceeds in escrow until the price of the replacement property is determined.
However, you will need to wait until the close of your replacement property before receiving the excess funds from your facilitator. Once the qualified intermediary releases the excess funds into your possession, you are automatically liable for the payment of taxes on the received funds.
Let’s look at an example to help you get a better understanding of boot and partial exchange. You sell a property with no mortgage and net $550,000. The replacement property is worth $400,000. Because the $150,000 can’t be invested in the replacement property, you’ll be taxed on it at the ordinary tax rate.
From the above example, the excess $150,000 is known as boot and since you failed to purchase a replacement property with an equal or higher value than your relinquished property, the IRS regards the exchange as partial.
Pros of a Partial 1031 Exchange
- The major advantage of doing a partial exchange is quick access to funds. If you have an urgent cash need, then doing a partial 1031 exchange is your best option. The excess funds from the exchange can be used for any reason you want since they will be taxed.
- Eliminate leverage and debt. For example, an office building in Annapolis costs $600,000 but only $100,000 left on the mortgage. You may decide to own a $500,000 replacement property free and clear and pay taxes on the $100,000 of the remaining boot. In this case a DST would be a viable alternative for your $100,000 of boot because you can invest in the DST and instead of a taxable partial exchange you would have a tax free complete exchange. DSTs are a great place for boot.
Cons of a Partial 1031 Exchange
You will pay taxes on boot.
In many cases, we consider a partial 1031 exchange as an excellent alternative to a traditional like-kind exchange. In our experience, we recommend partial exchanges when the seller has a financial planning need that requires some but not all of the capital from a sale. For example, it is not unusual for someone to sell a property that has no debt on it and outside of their home, it may represent close to 100% of their assets. Furthermore, when they sell, they want nothing to do with tenants or active real estate management, which indicates a DST it is their best tax-wise opportunity. Unfortunately, DSTs are not known for either their liquidity or ability to borrow against should someone need immediate money or emergency money. In these types of cases, it is wise to keep some money in reserve for a rainy day, even if you must pay taxes on it.
Before doing a partial exchange or a traditional 1031 exchange you should endeavor to consult your tax advisor for more assistance regarding your exchange situation. Get your facts before proceeding.