Over the last few years, we have had several clients walk into our office or call us on the phone asking the following question, Can I put some cash in my pocket at closing and still perform an IRC 1031 exchange?” The answer is yes. This is called a partial exchange and is permitted under Section 1031 of the tax code.
What is a Partial 1031 Exchange?
In a partial exchange, the taxpayer decides to defer some capital gain taxes and pay potentially recognized gain on the cash proceeds received or a partial reinvestment on the replacement property mortgage compared to the relinquished property mortgage.
Please feel free to reach out to us at Sera Capital to discuss the possibility and feasibility of you or your client’s next partial 1031 Exchange.
How Does Partial 1031 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 properties, you may request to receive a portion of the money from the sale at the closing of the sale or at any time after that.
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 to 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 paying taxes on the received funds.
How Is a Partial 1031 Taxed?
Partial 1031 exchange or boot can be taxed in three different ways, which can be confusing for a first-time exchanger. You’ll have to figure out which rates to apply to varying proportions of your gains, depending on:
- How much depreciation you claimed while owning the property
- What kind of depreciation did you claim?
- How much profit (capital gains) you realized on the sale.
Typically, your partial 1031 exchange will be taxed in the following ways:
|Type of Tax||Rate|
|Regular depreciation recapture||Regular depreciation recapture is taxed as ordinary income, so this is your personal income tax rate, capped at 25%|
|Excess depreciation recapture||Excess depreciation recapture is taxed at personal income tax rates, up to 35%|
|Capital gains||If you made more than $40,000, your capital gains tax rate will be at least 15%. It’ll rise to 20% if you made more than $445,850.|
Understanding Partial 1031 Exchange Gain Calculations
Partial 1031 exchange comes with several important aspects that need to be fully understood to enable exchangers to successfully defer capital gains while partially reinvesting some of the proceeds from the sale of their relinquished property. In this section, we will highlight some partial 1031 exchange examples.
Partial 1031 Exchange Boot Example
There are two major types of boots ─ cash boot and mortgage boot. Let’s look at two examples to illustrate how these two types of boot work.
- Cash boot in a partial 1031 exchange
Say you’re selling a $500k investment property that’s fully paid off, and you’ve planned to reinvest the $500k in cash from the sale through a 1031 exchange to defer your capital gains taxes.
However, your replacement property is priced at $350,000. Since you’re not reinvesting all the proceeds from the sale of your old property, you are simply doing a partial 1031 exchange. That excess $150,000 is considered cash boot and is subject to capital gains as well as depreciation recapture taxes.
- Mortgage boot in a partial 1031 exchange
Mortgage boot is incurred when you fail to replace the value of the mortgage relief generated from the sale of the sold property. In line with our previous example, let’s say you sell an investment property for $500k, and you paid off a remaining $200,000 on the mortgage.
If you use a 1031 exchange to reinvest that money in a $400,000 property, taking on $100,000 in new debt. That $100,000 gap between what you paid off on the initial mortgage and what you’re taking on is considered mortgage boot, which can always be offset by bringing new cash to the table.
Mortgage boot is a commonly misunderstood topic, and it’s good to have an experienced qualified intermediary to help you address it or even avoid it. Contact us, and we’ll help you out!
Pro’s And Con’s
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 since they will be taxed.
The major disadvantage of doing a partial 1031 exchange is paying taxes on the boot received during the exchange.
A partial 1031 exchange is an excellent option for real estate investors looking to receive some cash and defer taxes. Don’t hesitate to call us today if you are looking to do a partial 1031 exchange or have questions about the partial 1031 exchange and depreciation recapture.