The top priority for any wise real estate investor is success that 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.
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.”
- 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.
Let’s walk through an example involving taking cash so the boot rules don’t trip you up. 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 that 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.
Executing 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 unknown as well.
In these circumstances, best practices call for an outside party — a qualified intermediary — to hold all of the property sale proceeds until the closing for the purchase of the replacement property takes place. On the other hand, if your new investment property has been identified and the reinvestment amount is known, you can receive your cash boot at the closing for the sale on the original property.
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.
