“Pro et Contra” Partial 1031 Exchange

“Pro et Con­tra” From Latin “Pro et Con­tra” typ­i­cal­ly trans­lates to “Pros” and “Cons”. Basi­cal­ly mean­ing argu­ments for, or against a par­tic­u­lar issue. When enter­ing or exit­ing a par­tial 1031 tax deferred exchange (either by design or acci­dent) there are pros and cons.

By Al DiNi­co­la, AIF®, CEPA ™
adinicola@namcoa.com
July 7, 2023
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC

There may be three rea­sons why a par­tial exchange occurred.  The rea­sons may be by design; one or more of your iden­ti­fied prop­er­ties became unavail­able for some rea­son, or; the final nego­ti­at­ed price on your replace­ment prop­er­ties did not use all the cash.

Inten­tion­al or Unin­ten­tion­al

If enter­ing a par­tial exchange by design, the real estate investor may be seek­ing to access cash tied up in the real estate for a vari­ety of pur­pos­es. The funds may be used to take a vaca­tion, busi­ness fund­ing, pay for a child’s col­lege or wed­ding or oth­er rea­sons. When you sell your prop­er­ty via a 1031 tax deferred exchange it is pos­si­ble (by design) to retain a por­tion of the funds. The oth­er two rea­sons, where you receive cash, may have occurred unin­ten­tion­al­ly.  

There are a vari­ety of rea­sons why all the cash may not be used in a 1031 exchange. If only a por­tion of the cash is used in the exchange, then that por­tion would enjoy the tax defer­ral.   Retain­ing a por­tion of the pro­ceeds is con­sid­ered a par­tial exchange. Par­tial exchanges hap­pen every day.  The pro­ceeds not invest­ed in a 1031 exchange is con­sid­ered “boot” and sub­ject to cap­i­tal gain tax­es. There is also anoth­er type of tax that would be due and that would be the recap­ture of depre­ci­a­tion tak­en on the prop­er­ty.  There may also be anoth­er type of boot called mort­gage boot. That is anoth­er top­ic for dis­cus­sion.

Par­tial Exchange Review

The IRS has very strict rules, guide­lines, tim­ing as well as oth­er reg­u­la­tions regard­ing suc­cess­ful­ly exe­cut­ing a 1031 tax deferred exchange. The planned par­tial exchange hap­pens when an investor knows specif­i­cal­ly, they want to retain pro­ceeds from the exchange after the replace­ment prop­er­ty is acquired.  Oth­er par­tial exchanges may occur when  investors may have iden­ti­fied mul­ti­ple prop­er­ties on their list and find out after the 45-day peri­od has expired that one of the prop­er­ties they intend­ed to pur­chase is no longer avail­able. Yet anoth­er par­tial exchange may occur when investors nego­ti­ate a price on the replace­ment prop­er­ty (low­er than the required mar­ket replace­ment val­ue) and have pro­ceeds left over.

First things first.

 We can­not empha­size enough the impor­tance of the Qual­i­fied Inter­me­di­ary (QI) hold­ing the pro­ceeds of sale of your relin­quished prop­er­ty.  After an investor clos­es on the relin­quished prop­er­ty and enters the 45-day iden­ti­fi­ca­tion peri­od, there are a lot of unknowns as to the actu­al cost of the replace­ment prop­er­ty. Once the final nego­ti­at­ed price has been estab­lished and all clos­ing cost have been esti­mat­ed the investor should have a good idea on the excess pro­ceeds that may be avail­able.  The investor may have designed for cash to be left over. If the cash left over is not by design, then a Delaware Statu­to­ry Trust (DST) may pro­vide a solu­tion.

Receiv­ing your Funds

So when can you receive the excess funds from the QI?  Actu­al­ly, it depends. It depends on a few items that may or may not have been includ­ed on your 45-day list.  We will elab­o­rate but in either case as soon as you receive the pro­ceeds, you are liable for pay­ing tax­es on the process you receive.

Why does it depend on how you filled out the 45-day form? If you have only placed one prop­er­ty on the form and suc­cess­ful­ly closed on the one prop­er­ty, then on the 46^th day the QI will return your excess pro­ceeds.  How­ev­er, if you have placed 2nd or 3rd prop­er­ties on the form and only closed on one prop­er­ty, then the QI is required to hold your funds for the 180 days and return on the 181^st day.

Step­ping back to under­stand

Here is an exam­ple of how the par­tial exchange may work. You just sold a prop­er­ty for $700,000 and there was no mort­gage on the prop­er­ty. The new prop­er­ty costs $500,000.  If you only close on the one prop­er­ty, and retain $200,000, you will be sub­ject to cap­i­tal gains tax­es as well as recap­ture depre­ci­a­tion. The $200,000 that is not rein­vest­ed into the replace­ment prop­er­ty is called boot. Under the 1031 reg­u­la­tions  the replace­ment prop­er­ty must be equal to or greater than the relin­quished prop­er­ty.

Are there pos­i­tives to a Par­tial 1031 Exchange?

One pos­i­tive of the par­tial exchange is the abil­i­ty to access your cash that was tied up in the real estate.  Access to cash may be need­ed for an emer­gency and once cash is received the investor may use the cash for any rea­son. Again, the cash is sub­ject to tax. DSTs have pro­vid­ed a viable solu­tion for left over cash or as a back up to replace­ment prop­er­ties that can­not be acquired.

DSTs also offer a poten­tial solu­tion when fail­ing to replace  lever­age and debt. A ques­tion often aris­es from investors who sell a prop­er­ty that has debt but wants to elim­i­nate future recourse debt. Here is an exam­ple.  The investor is sell­ing a prop­er­ty for $700,000 and has a remain­ing loan on the prop­er­ty in the amount of $100,000. The investor locates a prop­er­ty for $600,000. The investor is avoid­ing apply­ing for and being respon­si­ble for debt in the amount to $100,000. The $100,000 loan that was paid off (and not replaced) would be con­sid­ered mort­gage boot and sub­ject­ed to being taxed. By struc­ture many DST come prepack­aged with non-recourse debt. Each DST will have their own loan to val­ue (LTV) and there are addi­tion­al DST alter­na­tives that may pro­vide a solu­tion to pro­vide a tax free (deferred tax) com­plete exchange.  DSTs have been a viable alter­na­tive for boot.

“Con­tra” The Draw­backs uti­liz­ing a Par­tial 1031 Exchange

The biggest draw­back would be the require­ment to pay tax­es on the cash boot or the mort­gage boot.

Addi­tion­al Com­ments.

Exe­cut­ing a par­tial exchange is an accept­able alter­na­tive to a typ­i­cal 1031 tax deferred exchange. Under­stand­ing your indi­vid­ual sit­u­a­tion is most impor­tant.  If an investor needs access to cash tied up in the real estate for oth­er finan­cial needs this may be the pru­dent course of action.  We have assist­ed investors explore the par­tial exchange as well as exe­cute the par­tial exchange.   We have assist­ed investors who have sold a prop­er­ty they have owned for thir­ty years.  Over the time of own­er­ship, the entire mort­gage has been paid off and now they have no debt. In addi­tion, the prop­er­ty rep­re­sent­ed close to 100% of their assets besides their pri­ma­ry res­i­dence.  The investor has grown tired of deal­ing with the ten­ants (toi­lets & trash) as well as active man­age­ment. The DST may pro­vide a great solu­tion for a pas­sive invest­ment. There are a few words of cau­tion. DSTs are con­sid­ered an ill-liq­uid invest­ment and do not pro­vide an oppor­tu­ni­ty to tap into for access­ing cash. You may also not be able to uti­lize a DST as col­lat­er­al to bor­row against.  The par­tial exchange may pro­vide you with access to cash albeit you will pay tax on the cash not rein­vest­ed but retained.

Please con­sult your CPA or tax advi­sor to dis­cuss your indi­vid­ual solu­tion. .

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.

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