Many investors assume that you cannot defer taxes via a 1031 Exchange unless you trade up in property value. Understanding the difference between a fully tax deferred exchange and a partially tax deferred exchange is important when planning investment strategy.
TL;DR: A 1031 Exchange does not have to be all or nothing. Investors may still qualify for 1031 tax deferral even if they take cash at closing, buy lower value Replacement Property, or do not fully replace debt. The taxable portion, known as “boot,” may trigger taxes while the remaining exchange may still qualify for tax deferral.
What is a Fully Tax Deferred 1031 Exchange?
A 1031 Exchange allows real estate investors to defer 100% of their capital gains tax liability when selling investment property and reinvesting into like kind Replacement Property. To achieve full tax deferral, the exchanger must purchase Replacement Property that is equal to or greater in both value and equity than the Relinquished Property and replace the value of debt with either new debt or additional cash.
What is a Partial 1031 Exchange?
A Partial Exchange occurs if an investor needs to purchase lower value Replacement Property or retain a portion of the sale proceeds at closing instead of fully reinvesting into their new property. The trade down in value or equity creates what is called “boot” and is subject to capital gains and depreciation recapture taxes. The good news is that these transactions may still provide worthwhile tax deferral under Section 1031 of the Tax Code, provided the boot is less than the realized gain.
The term boot refers to non-like-kind property received in an exchange. It is important to understand that the receipt of boot does not disqualify the exchange; it merely introduces a taxable gain into the transaction. The Exchanger has a “partially tax deferred exchange” rather than a “fully tax deferred exchange”. Accordingly, any non-like-kind property received in an exchange will be taxed, up to the amount of realized gain from the sale of the Relinquished Property.
Important Considerations for Full or Partial 1031 Deferral
Can I Take Money at Closing During a 1031 Exchange?
You can take money at closing during a 1031 Exchange. However, the cash you keep may become taxable “boot” while the remaining portion of the transaction may still qualify for tax deferral.
What Happens If I Do Not Replace My Debt?
For full tax deferral, the value of debt paid off during the sale must be replaced with new debt or additional cash. If the value of debt is not replaced, the difference may create taxable boot.
Careful planning before closing is important. Investors should work closely with their Qualified Intermediary, tax advisor, lender, and closing agents to help avoid unintentionally creating a Partial Exchange.
Examples of a Partial Exchange
Taking Cash at the Sale of the Relinquished Property
Example: Lila is selling her rental townhouse for $1,000,000. At the close of escrow, she wants to receive $100,000 to invest in the stock market and utilize her remaining funds for her 1031 Exchange. The $100,000 is not part of the Tax Deferred Exchange. If Lila takes any cash from the sale, that amount becomes taxable boot.
Buying Down in Value
Example: Lila is selling her rental townhouse for $1,000,000 and plans to utilize a 1031 Exchange to defer her taxes. However, she can only locate new property with a sales price of $800,000 that she desires to purchase. The $200,000 not reinvested into like kind property will be taxable.
Not Replacing Debt
Example: Lila is selling her rental townhouse for $1,000,000 with a $500,000 mortgage. Lila exchanges into a rental condo worth $800,000 and reinvests her equity of $500,000. Since Lila has gone down in value, she hasn’t replaced $200,000 in debt which creates taxable boot.
Potential Solutions to Achieve Full 1031 Exchange Tax Deferral
If your goal is to defer 100% of your taxes, consider these potential solutions:
- Instead of taking cash from the sale of the old Relinquished Property, reinvest all the proceeds into new Replacement Property and then do a cash out refinance in a separate transaction after the closing. It is generally considered less risky to refinance the new Replacement Property (rather than the old Relinquished Property) through a separate post-closing transaction.
- Offset the gain on part or all of cash withheld with carryforward losses or expensing deductions for that tax year.
- If you cannot locate enough property that equals or exceeds the value of your old Relinquished Property, consider acquiring a fractional interest in additional Replacement Property, such as a beneficial interest in a Delaware Statutory Trust (DST). DSTs allow taxpayers to acquire small fractional interests in portfolios of properties such as multi-family housing, student housing, storage locker facilities, etc.
Understanding When a Partial Exchange Makes Sense
The key question investors should ask is how much of the transaction remains tax deferred versus how much becomes taxable. A Partial Exchange may still provide meaningful tax deferral benefits. However, if too much cash is retained or debt is not replaced, the taxable portion of the transaction may negate the benefits of completing the exchange. Investors should evaluate the numbers carefully with their tax advisor before assuming a Partial Exchange is beneficial.
Whether your 1031 goal is full or partial deferral, work with your tax and legal advisors to strategically make your 1031 work best for your situation. Please feel free to reach out to one of your local IPX1031 experts to discuss the possibility and feasibility of your or your client’s next 1031 Exchange.
Key Strategic Partial 1031 Exchange Takeaways
- A fully tax deferred 1031 Exchange generally requires purchasing Replacement Property equal to or greater in value and equity than the Relinquished Property and replacing the value of debt.
- A Partial Exchange occurs when an investor receives taxable “boot,” such as cash retained at closing or debt not replaced.
- Receiving boot does not disqualify the exchange. Only the boot portion generally becomes taxable.
- Common causes of taxable boot include taking cash proceeds, buying down in value, or reducing debt without replacing it.
- Partial Exchanges may still provide meaningful tax deferral benefits depending on the investor’s goals and tax situation.
Frequently Asked Questions About Partial 1031 Exchanges
Can I still do a 1031 Exchange if I take cash at closing?
Yes. Taking cash at closing does not automatically disqualify the exchange. However, the cash received generally becomes taxable “boot.”
What exactly do I get taxed on in a Partial Exchange?
Taxes generally apply only to the taxable “boot” portion of the exchange, such as cash received, debt not replaced, or other non like kind property. This taxable portion may be subject to:
- Federal capital gains taxes
- State capital gains taxes, if applicable
- Depreciation recapture taxes
- Net Investment Income Tax (NIIT), if applicable
What is “boot” in a 1031 Exchange?
The term boot refers to non-like-kind property received in an exchange. Boot is commonly received in the form of cash, an installment note, debt relief, or other non-like-kind property and may become taxable.
What does adjusted basis mean?
Adjusted basis is generally the original purchase price of the property plus improvements and minus depreciation taken over time. This number plays a major role in determining taxable gain in a 1031 Exchange. Investors who are unsure of their adjusted basis should consult their tax advisor and may also use the IPX1031 Capital Gains Estimator tool as a starting point for estimating potential gain exposure.
Is a 1031 Exchange all or nothing?
No. Many investors are unaware that Partial Exchanges may still allow for partial tax deferral. Investors may still receive partial tax deferral even if they:
- Receive some cash from the sale
- Buy lower value Replacement Property
- Do not reinvest all proceeds
- Do not fully replace the value of debt
IPX1031. The best choice for your 1031.
IPX1031 is the largest and one of the oldest Qualified Intermediaries in the United States. As a wholly owned subsidiary of Fidelity National Financial (NYSE:FNF), a Fortune 500 company, IPX1031 provides industry leading security for your exchange funds as well as considerable expertise and experience in facilitating all types of 1031 Exchanges. Taxpayers’ funds are held in segregated accounts using the Exchanger’s taxpayer identification number. Our nationwide staff, which includes industry experts, veteran attorneys and accountants, are available to help you and your legal and tax advisors. For additional information regarding IPX1031 and questions on 1031 Exchanges, please review:
Recommended 1031 Exchange Resources
