Partial 1031 Exchange: What is it & How to Do it
Updated: Aug 31
The top priority for any wise real estate investor is success which can be measured in profits. When your capital gains come with some flexibility, that only makes the pot that much sweeter.
If you are thinking of executing a 1031 exchange so that you can both defer capital gains taxes and parlay your gains into more future profits, the good news is that some flexibility is built into the rules — even though they seem complex and beset with stipulations.
If you plan to immediately use some of the cash from a real estate sale and still defer taxes on the rest of your gains, a partial 1031 exchange provides the flexibility you’re seeking.
The 1031 Exchange: An Overview
The 1031 exchange is a great tool for deferring capital gains taxes and depreciation recapture when selling a real estate investment. In a standard 1031 exchange, individuals can potentially avoid paying up to 40% in taxes that would be incurred in a traditional real estate transaction.
This tax deferral strategy involves swapping one investment property for another similar property of equal or greater value. To qualify, the new property must meet specific criteria:
The replacement property must have a value equal to or higher than the sale price of the original property.
All proceeds from the sale must be reinvested into the new property.
The mortgage on the new property should be equal to or greater than the final mortgage balance on the original property.
Alternatively, cash can be added outside the exchange to fulfill the mortgage requirement.
What Is a Partial 1031 Exchange?
Without getting into too much detail or covering all of the rules, a 1031 exchange basically entails swapping one real estate investment property for another similar type of property of equal or greater value. The benefit is that investors can defer capital gains taxes on the sale of the original property.
Keeping a portion of the sales proceeds rather than reinvesting the full amount would make it a partial 1031 exchange.
The amount that is not reinvested is called “boot.”
The boot can be in the form of cash or a reduction in the debt on the new property versus the relinquished property — called “mortgage boot.”
Mortgage boot is taxable in the tax year of the sale, just like cash boot.
Say that you sell an investment property for $5 million. You want to spend some of your profits on a new home, but you also want to defer most of your capital gains taxes, so you reinvest $4 million in a 1031 exchange property.
The $1 million in proceeds you are not reinvesting is the boot amount. This sum is subject to capital gains taxes and depreciation recapture taxes in the tax year of the sale, while the rest of your gains won’t be taxable until you cash in in the future.
How to Do a Partial 1031 Exchange?
Carrying out a partial 1031 exchange is similar to executing a standard 1031 exchange but with some notable exceptions, such as how sales proceeds are handled.
With 1031 exchanges, investors sometimes don’t have a specific new investment property lined up when the initial property sale closes, and thus the amount of equity needed for the next purchase is unknown — and the exact boot is also unknown.
1. Enlist the Services of a Qualified Intermediary (QI)
When embarking on a 1031 exchange, partnering with a Qualified Intermediary (QI) is essential. Acting as a third-party facilitator, the QI ensures compliance with IRS regulations by safeguarding the sale proceeds of the relinquished property and facilitating the acquisition of the replacement property.
2. Determine the Relinquished Property
Identify the "relinquished property" you plan to sell as part of the exchange, ensuring it meets the criteria for a like-kind exchange.
3. Identify the Replacement Property
Alongside identifying the relinquished property, it is crucial to promptly identify a suitable replacement property that meets the like-kind criteria within the designated timeframe.
4. Calculate the Partial Exchange Amount
You need to decide how much money you get from selling the old property you want to use to buy the new property. The part you don't use for buying the new property will be considered taxable income and subject to capital gains taxes.
5. Proceed with the Sale of the Relinquished Property
After identifying the replacement property, proceed with selling the relinquished property, and rely on the Qualified Intermediary (QI) to handle the sale proceeds by securely holding them in a segregated account.
6. Acquire the Replacement Property
During the designated timeframe (typically 180 days), acquire the replacement property with the assistance of the Qualified Intermediary (QI), who will facilitate the transfer of funds from the segregated account to purchase the replacement property.
7. Finalize the Exchange
You have effectively completed a Partial 1031 exchange by adhering to the outlined steps. It is vital to seek guidance from tax professionals or real estate exchange specialists to ensure compliance with IRS rules and regulations.
By partnering with Precision Global Corporation and adhering to the regulations, you can successfully navigate a partial 1031 exchange, avoiding disqualification and preserving tax advantages.
How Is Partial 1031 Taxed?
Partial 1031 exchanges or boots can be subject to taxation in three ways, confusing first-time exchangers. The tax rates depend on factors such as:
depreciation claimed type of depreciation
capital gains realized from the sale
Generally, partial 1031 exchanges are taxed in the following manners:
Type of Tax
Regular Depreciation Recapture
Depreciation recapture incurs ordinary income tax at your personal tax rate, with a maximum of 25%.
Excess Depreciation Recapture
Excess depreciation recapture is taxed at personal income tax rates, reaching a maximum of 35%.
Capital gains tax rates start at 15% for incomes exceeding $40,000 and can increase to 20% for incomes surpassing $445,850.
Understanding 1031 Partial Exchange Gains Calculations
Understanding the key aspects of a Partial 1031 exchange is crucial for exchangers to effectively defer capital gains while partially reinvesting proceeds from the sale of their relinquished property.
There are two main types of boots: cash boot and mortgage boot. Let’s look at two partial 1031 exchange examples to demonstrate how each type works.
1. Cash Boot
In a partial 1031 exchange, if you don't reinvest all the proceeds from the sale, the remaining amount (cash boot) is subject to capital gains and depreciation recapture taxes.
For example, if your replacement property costs $350,000 and you sold your old property for $500,000, the $150,000 difference would be considered cash boot.
2. Mortgage Boot
Consider the scenario where you sell a fully paid-off investment property worth $500k. If you utilize a 1031 exchange and reinvest the proceeds in a $400,000 property while taking on $100,000 in new debt, the difference between the initial mortgage paid off and the new debt is known as mortgage boot.
Pros and Cons of a Partial 1031 Exchange
Here are some key advantages and drawbacks to consider when deciding whether or not a partial 1031 exchange is right for you.
A partial 1031 Exchange offers investors two primary advantages: receiving cash and lowering their debt levels.
A partial exchange allows investors to retain cash from the sale of the relinquished property.
It allows for reducing debt levels on the replacement property, creating a potentially safer and more stable investment scenario.
Cons Here are some of the potential downsides to consider before taking part in a Partial 1031 exchange:
There will be a tax liability when cash is received in a partial 1031 exchange.
Determining the exact tax liability can be challenging and intricate. It is advisable to seek guidance from a qualified tax advisor to ensure accurate reporting and compliance with the tax code.
These advantages and disadvantages should be considered carefully before pursuing a partial 1031 Exchange.
Is a Partial 1031 Exchange the Right Decision?
When considering a partial 1031 exchange, investors should evaluate if it aligns with their investment goals and financial situation. Factors to consider include:
Property cost basis
Plans for exchange proceeds
Given the complexity of this decision, consulting with a qualified CPA or tax expert well-versed in the Internal Revenue Code (IRC) is advisable.
Maximize Your Investment Potential with Expert Guidance
There are a lot of technicalities to the rules for partial 1031 exchanges. If they are not precisely followed, your entire exchange could be disqualified, and you would lose any tax advantages.
For that reason — and because tax laws constantly change — advance planning, expert assistance, and due diligence are critical. At Precision Global Corporation, we specialize in 1031 exchange opportunities and are happy to help. Contact us today for more information or to get started.
Please note that Precision Global Corporation (PGC) is not a certified public accountant (CPA) firm, and the information provided in this article should not be considered as professional tax advice. Content provided by PGC is for general informational purposes only.
Tax regulations vary by location and can change over time. It is recommended to consult with a qualified CPA or tax advisor who is knowledgeable about the specific tax laws applicable to your situation. They can provide personalized guidance tailored to your circumstances.
Precision Global Corporation does not accept liability for any actions taken based on the information presented in this article. For accurate and personalized tax advice, please consult a local CPA or tax professional.