One of the biggest complaints that many real estate investors have about a traditional 1031 exchange is that it leaves them property rich but cash poor.
To be sure, there are plenty of benefits in conducting a 1031 exchange, such as deferring the payment of capital gains tax, tax on depreciation recapture, and scaling up an investment property portfolio. But, one of the biggest drawbacks is that you have to use all of your sales proceeds during a 1031 to avoid getting hit with a big tax bill.
A partial 1031 exchange can solve that problem. By doing a partial 1031 you can use some of your proceeds for reinvesting while pulling out taxable cash for other uses.
What is a Partial 1031 Exchange?
Normally a 1031 exchange is used to defer the capital gains tax owed by reinvesting 100% of the proceeds from the sale of a relinquished property into the new replacement property.
However, there are times when you may want to hold back part of the sales proceeds and use the money for another purpose. A partial exchange allows you to retain part of the funds from the relinquished property by creating “boot.”
How Boot is Created in a 1031 Exchange
The money that is not reinvested is called “boot” and is subject to capital gains tax and taxes on pro rata amount of depreciation that is recaptured, while the remaining funds used in the 1031 exchange can be reinvested with taxes completely deferred.
In the following sections of this article, we’ll dig into the details of a partial 1031 exchange.
But first, let’s take a quick look at the major rules of a regular delayed 1031 tax-deferred exchange that must be followed to defer all of the capital gains tax owed.
Rules of a Traditional Delayed 1031 Exchange
Rule #1: Like-Kind
Property must be “like-kind” and used for business or investment purposes. According to the IRS, “like-kind” property doesn’t mean the same as or equal to. Instead, any type of real estate that is used for investment can be used in a 1031 exchange, even if the asset class is different.
For example, a vacant lot can be exchanged for a turnkey single-family rental, a commercial property can be exchanged for a vacant residential rental property, or an office building can be exchanged for a portfolio of rental houses and multi-family properties.
Rule #2: Timing
After the sale of the relinquished property is completed and the sales proceeds are placed with a qualified intermediary, there are two timelines to follow:
Within 45 days of the closing of the sale of the relinquished property, identify one or more replacement properties
Within 180 days of the closing of the sale of the relinquished property, close on the purchase of the replacement property (or properties) and have the qualified intermediary transfer the sales proceeds they are holding to the seller of the replacement property
Rule #3: Value
The value of the replacement property being acquired must be equal to or greater than the value of the property being sold or relinquished.
So, if you’re an investor who sells a rental property for $1 million in a high-cost market like the San Francisco Bay Area, you could turn around and buy three, four, or even five homes in smaller secondary markets for a combined purchase price of $1 million and defer paying capital gains tax.
Rule #4: Debt
The amount of debt on the replacement property and the relinquished property must be the same. If your outstanding mortgage balance on the Bay Area house was $500,000 you would need to use at least $500,000 in debt financing to acquire your replacement property or properties.
Rule #5: Equity
The amount of equity in the replacement property must be at least the same as the equity in the relinquished property.
For example, the San Francisco rental property has a market value of $1 million, with $500,000 in equity and $500,000 in debt. You found a good deal on a small portfolio of multi-family property in Dallas that another investor is willing to sell for $1.1 million.
You’ve already met the requirements of Rule #3 by acquiring a replacement property with a value equal to or greater than the value of the relinquished property. However, in order to meet the debt requirements of Rule #4 and have at least the same amount of equity, your new mortgage on the replacement property could not exceed $600,000.
Why Conduct a Partial 1031 Exchange?
A partial 1031 exchange can occur in two different ways: On purpose or by accident.
As a real estate investor, you may intentionally conduct a partial 1031 exchange by instructing your QI (Qualified Intermediary) to disburse a specific amount of the funds from the sale of the relinquished property. However, if you’re not careful, a partial 1031 exchange can also occur when taxable boot is accidentally created.
Doing a partial 1031 exchange on purpose
- Use part of your net proceeds for personal use or to invest somewhere else, such as funding a 529 qualified tuition plan for your new-born child or buying shares of a promising IPO.
- A good replacement property with the same or greater value to your relinquished property can’t be found. So, instead of buying a bad property simply to invest all of your sales proceeds, you purchase a good property that costs less and pay taxes on the boot.
- Eliminate leverage and debt service completely. For example, let’s say our rental property in San Francisco had a market value of $1 million but only $100,000 left on the mortgage. You may decide it makes more business sense to own a $900,000 replacement property free and clear and pay taxes on the $100,000 of the remaining boot.
Accidentally creating a partial 1031 exchange and boot
There are two ways that boot can accidentally be created during a 1031 tax deferred exchange:1. Cash boot
Is created when the value of the replacement property is less than the value of the property being relinquished or sold. In order for a 1031 exchange to completely defer any capital gains tax, all of the proceeds from a sale must be reinvested to defer all capital gain taxes.2. Mortgage boot
Is created when the debt on the replacement property is less than the remaining debt you had on the relinquished property.
For example, if our investor in San Francisco purchased a replacement property worth $1 million using a mortgage of $400,000 he would create a taxable mortgage boot of $100,000 (the difference between the outstanding mortgage of $500,000 on the relinquished property and a new mortgage on the replacement property of $400,000).
Creative Ways to Get Your Money Back
The main reason for conducting a partial 1031 exchange (unless you do one by accident) is to pull some money out of the transaction while reinvesting the rest with taxes deferred.
However, with a little bit of advance planning, it’s possible to have your cake and eat it too by conducting a normal delayed 1031 exchange that defers all of your capital gains tax and still gets some money back too.
Here are two creative ways to get some money back and still defer your capital gains tax liability by 100%:
1. Cash-out refinancing
Doing a cash-out refinance as a separate transaction after you close on your replacement property is one way to pull some cash out after the fact.
Our investor with the $1 million property in San Francisco had 50% debt and 50% equity. That LTV of 50% is very low, even for the most conservative investor.
Now let’s say the investor wants to accomplish three things: 1) Receive all of the capital gains tax deferral benefits of a regular 1031 exchange, 2) Maintain a conservative LTV of 75%, and 3) Pull money out of the transaction.
He would follow these three steps:
- Acquire a replacement property with a value of at least $1 million using a mortgage of $500,000 (the same as the outstanding mortgage balance on the relinquished property)
- After the regular 1031 exchange closes, the investor does a cash-out refinance with a new mortgage of $750,000 creating a still conservative LTV of 75%
- Use the $250,000 in cash pulled out of the refinance for another use
If you have outstanding losses from other transactions that you’ve been carrying forward or deductions that you haven’t yet completely expensed, you may be able to use those to offset any capital gains tax liability generated by the boot in a partial 1031 exchange.
A partial 1031 is a good alternative to a traditional 1031 exchange that allows you to reinvest some of your sales proceeds and defer paying capital gains tax while pulling some money out of the transaction:
A partial 1031 exchange occurs when less than 100% of your sales proceeds from a relinquished property are invested in a replacement property
Taxable boot in a partial 1031 exchange is created when cash is pulled out or when the mortgage on the replacement property is less than the mortgage balance of the relinquished property
Reasons for conducting a partial 1031 exchange include generating cash on hand for other personal or investment uses, or when you can’t find a good replacement property that’s worth more than the property being relinquished.