Are there advantages of a Partial 1031 Exchange?

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.

Post­script

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 adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 410 Peachtree Park­way Suite 4245, Cum­ming, GA 30041. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC