Al DiNicola AIF® NAMCOA RIA
Over the years my real estate broker friends have been involved with partial 1031 exchanges. Unfortunately, this was not by design but may have been because the broker could not find the exact replacement property solution. However, that is another topic for a later article on how to structure a proper 1031 exchange. That structure may utilize a Delaware Statutory Trust (DST) as the main solution or as a backup. The real issue or question may be, how do I keep part of the proceeds of the sale of my property and do a 1031 tax deferred exchange with the balance. Can I do a partial exchange? The IRS 1031 code does permit this type of split or partial exchange. Having said that there are also details that need to be reviewed by the investor to not only satisfy the 1031 tax deferred exchange but protect the investor and limit the risk exposure.
Partial 1031 Exchange defined
Executing a full 1031 exchange the investor may defer the capital gains on the sale of a relinquished property. If the exchange is less than a full exchange (a partial exchange), the taxpayer can retain part of the gain and defer capital gain taxes on the balance. Retaining any amount of the gain (meaning not investing all the proceeds of the sale of the relinquished property) triggers a taxable event for the investor. Another trigger for capital gains taxes may be failing to replace the mortgage that was paid off from the sale of the relinquished property.
Details of the Partial 1031 Exchange
Strick adherence to the IRS rules is required for any 1031 exchange including a partial exchange. Normally the price of the replacement property may drive the decision to retain part of the proceeds. There have been studies that suggest a 1031 exchange investor may overpay for the replacement property since the investor must spend all the proceeds. (An alternative strategy may be to have a DST as the backup, again another topic). Let us imagine you have found a great replacement property that costs less than the property you have sold. You may proceed to closing and keep whatever proceeds you have not spent. If you know what your final cost will be you may request the excess proceeds from the QI prior to the closing on the replacement property. The danger with taking your proceeds before you close on the replacement property creates uncertainty with what you will need (in cash) to close on the replacement property. A QI typically does not object to holding your proceeds for as long as you need to be retained (Oh my, that is another topic- the QI holding your proceeds for an extended period). So, what can you do? You may want to retain a contingency amount with the QI. There is good news, in a way, if you wait to receive your excess funds from the QI. Wait, what, good news? You will not be liable to pay any taxes on the funds until you receive from the QI. Do not confuse the QI holding your excess fund when you fail to close on an identified property on your 45-day replacement list. The required QI holding period of your funds may be 181 days (yet another topic).
Potential tax confusion or tax options with a Partial 1031
There can be confusion on the way to manage the taxes on a Partial 1031 exchange. The excess funds or “boot” can be taxed in a few separate ways. For first time exchangers there is confusion. Even veteran exchangers need a refresher course. So, at times it may be a toss-up on which rates you use. You will have to figure out which rates to apply to varying proportions of your gains, depending on many factors.
During ownership how did you manage depreciation? The IRS assumes you have taken depreciation even though you may not have realized any tax benefits during ownership. Commercial assets are depreciated over 39 years while residential over 27.5. There are the actual percentages based on the month of acquisition and the month of sale. Sounds complicated but there are formulas to make those calculations. Your accountant may have utilized accelerated depreciation. Bottom line, know the depreciation amount. Most CPA can assist in calculation of the profits you make on the sale. Yes, this would be the capital gains on the sale.
Let us analyze the potential tax situation on a partial 1031 exchange. This could be the tale of the Tax Tape. A throwback to the old adding machines that had print out tape.
- There is a recapture (tax) on the amount of depreciation that you have taken. Depreciation is recapture as ordinary income capped at 25%. Typically, the amount is stated at 25%. The depreciation taken will reduce your basis in the real estate (offset potentially by your capital improvements in the property).
- You may have also taken excess depreciation on certain portions of your asset. This is recapture again at your personal rate up to 35%.
- Once you calculate your capital gains (offset by depreciation) there will be a tax on the net capital gains. The rate will be 15% if you have made more than $40,000 the year of sale. The capital gains will increase to 20% if you make more than $445,850.
- Do not forget the affordable health care tax of 3.8% on the total capital gains amount.
It is possible to execute a Partial 1031 Exchange. The challenge is to understand the Gain Calculations. It is always important to hi-lite examples of the 1031 partial exchange. Let us start with potential 1031 exchange boot in a Partial Exchange.
Depending on how your exchange is structured if you receive cash that is referenced as cash boot. If you do not replace the debt that was paid off that is debt or mortgage boot. Here are examples of how this boot issue may work. As a side note the word boot may have come from an old English term. This is not used in the IRS code. There are references to the meaning “something given in addition to.”
If you execute a partial exchange and retain cash that is Cash boot. Here is an example.
- You own an investment real estate property and there is no loan on the property and let us imagine (hypothetically) you sell that property for $800,000. Your intentions are to acquire a replacement property using the entire $800,000. Under this scenario using a 1031 tax deferred exchange you would defer any capital gains taxes (and recapture of depreciation) until a later date.
- Depending on how lucky or skilled you are at locating a replacement property you may not find the exact match. You did locate a genuinely nice property that cost $600,000. What happens to the $200,000 difference? This would be considered a partial exchange. This is totally permitted.
- The $200,000 you have not reinvested is known as “Cash Boot”. There are calculations to establish the capital gain as well as the recapture of depreciation on your investment. In any event you will be responsible for the taxes on both items.
How is a mortgage payoff managed in a partial 1031 tax deferred exchange?
- One of the requirements to successfully execute a 1031 tax deferred exchange is to replace the mortgage that was paid off on the property you have sold. If you do not replace the same amount of mortgage satisfied on the property sold, you will have what is known as mortgage boot. We will use the same hypothetical example above with a $300,000 loan.
- Let us take the same genuinely nice building from the example above that cost $600,000. You use your cash proceeds of $500,000 ($800,000 minus the mortgage of $300,000) and you arrange a loan for the balance of $100,000. There is now a delta of $200,000 between the old loan and the new loan. This is known as mortgage boot. (Mortgage boot may be offset by bringing more cash to the transaction).
Cash boot may be easier to understand than mortgage boot. Like other aspects of the IRS code, it is best to consult your CAP or tax consultant. Part of our work deals with balancing the cash as well as debt needs of the 1031 tax deferred exchange utilizing potentially a Delaware Statutory Trust (DST).
Are there any advantages or disadvantages of a partial exchange?
One major advantage of a partial exchange may be access to your proceeds. You may have an emergency and need the cash for another purpose. Once you have paid your capital gains taxes (or proportional amount) you are free to use those net proceeds for any purpose you may have.
Mortgage boot is another issue. You may need to come out of pocket for the capital gains taxes on the amount of mortgage you did not replace. For example, if the delta from above was $200,000 and if we use a simple capital gains rate of 20%, you pay $40,000 for not replacing the debt. I used a simple capital gains rate, but your rate may be different especially when calculation the recapture of depreciation and the 3.8% Medicare tax. Also, you may be responsible for your state income taxes as well.
Real estate investors can access part of their proceeds by executing a 1031 tax deferred partial exchange. If you have capital losses, you may also offset capital gains thus reducing or eliminating your capital gains taxes. This provides access to your cash. However, take the time to fully investigate all the surrounding aspect of the partial exchange.
Disclosure. DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email firstname.lastname@example.org.
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