To have a fully tax-deferred 1031 exchange, an exchanger must: (1) buy replacement property of equal or greater value; and (2) use all the net proceeds from the relinquished property towards their replacement properties.
For a variety of reasons, sometimes exchangers cannot (or choose not) to meet one of these requirements. For example, an exchanger may decide to take some cash from the sale of their relinquished property to use for some other purpose; or they find the “perfect” replacement property but it is of lower value than their relinquished property. Such exchanges can still be successfully completed and are known as “partial” 1031 exchanges. In partial exchanges, the money received, or the value of the relinquished property that is not replaced, is known as “boot” and is taxable as a capital gain. Here are two specific examples:
- Kate sells her investment property for $1,000,000. After closing costs, she will net $950,000. She takes $50,000 in cash from the sale and the $900,000 balance is sent to her 1031 exchange accommodator. The $50,000 in cash that Kate took from the sale is boot and, subject to some of the suggestions below, she will be taxed on it at the capital gains rate.
- Byron sells his investment property for $1,000,000. After paying $50,000 in closing costs and paying off a $150,000 mortgage, he nets $800,000 in cash. All $800K goes to Byron’s 1031 exchange accommodator. However, instead of buying a new property for $950K (the gross sale price of his relinquished property, less his $50K in closing costs) or greater, Byron instead decides to pay all cash for an $800,000 replacement property. In this scenario, the $150,000 “shortfall” (the difference between the $950K he needed to buy and the $800K property he actually bought) is boot and will be taxed at the capital gains rate.
If an exchanger is considering a partial exchange, that does not mean they must resign themselves to paying capital gains taxes. Here are a few potential solutions:
- Instead of taking cash from the sale of the relinquished property, an exchanger can use all of their sale proceeds towards their replacement property and then later do a cash-out refinance on the replacement property.
- If an exchanger buys replacement property of lesser value, they can consider purchasing a fractional ownership interest in additional replacement property, such as a Delaware Statutory Trust (DST) to make up for the shortfall.
- The exchanger can speak with their CPA or tax advisor to determine if they are able to offset their boot with carryforward losses, or with depreciation on their newly acquired property.
The takeaway here is that 1031 exchanges are not an all-or-nothing propositions and one can complete a partial exchange and still avoid most, if not all, capital gains tax liability. As each situation is unique, exchangers should always seek the guidance of a tax advisor prior to beginning their transactions.
Please speak with your tax advisor and contact one of our 1031 exchange experts for more details.
If you or someone you know has questions about the 1031 exchange process, we at Peak 1031 Exchange are your qualified experts who are here to help. Contact us today at [email protected] or by calling us at 866-357-1031 to discuss the deferral of capital gains taxes with a 1031 exchange.