When the time comes to sell an investment property, the potential for substantial financial gain is exciting. However, the prospect of dealing with substantial tax implications for highly appreciated real estate assets can be daunting.
Enter the realm of the 1031 exchange – a powerful tool that enables you to defer capital gains taxes triggered by the sale. Yet, there are instances where investors wish to retain a portion of their sales proceeds to bolster their immediate liquidity. If you find yourself in this situation, here’s some good news: opting for a partial 1031 exchange, also referred to as a split exchange, might be your ideal strategy.
This innovative tax approach provides the flexibility to extract cash from the sale of your relinquished property. The intriguing aspect is that you aren’t obliged to reinvest the entirety of your sales proceeds into a like-kind replacement property. In essence, you can relish the advantages of a 1031 exchange while retaining some liquid assets.
However, it’s essential to be aware of the nuances. In a partial 1031 exchange, you choose to exchange only a portion of your sales proceeds, allowing you to maintain a cash reserve for personal use. It’s a trade-off, though, as the cash retained will be subject to taxation. Any funds not reinvested into the replacement asset will be subject to capital gains taxes.
For instance, imagine you sold an investment property for $1 million and aimed to reinvest in a replacement property valued at $800,000. This situation creates a $200,000 gap. While you can certainly keep this amount, it’s important to recognize that doing so triggers capital gains (and potential depreciation recapture) taxes on the $200,000. This residual amount not reinvested into a partial like-kind exchange is referred to as “boot.”
The assessment of capital gains taxes hinges on your income and filing status. Should you have owned the initial investment property for over a year, the capital gains tax rates could stand at 0%, 15%, or 20%, contingent upon your specific circumstances. Conversely, short-term capital gains are subject to your standard tax rate.
Bear in mind that the boot concept takes diverse forms. One variant is cash boot, arising from the cash received after relinquishing the property. On the other hand, mortgage boot stems from a reduction in mortgage obligations on the replacement property when compared to the debt associated with the relinquished property. It’s imperative to note that boot – in either manifestation – attracts taxation, and the applicable tax rate hinges on the origin of the boot itself.
Understanding these intricacies allows investors to make informed decisions while harnessing the power of partial 1031 exchanges for enhanced financial management and optimized real estate portfolios.”
How to Complete a Partial Like-Kind Exchange?
The rules and restrictions involved in a partial 1031 exchange are the same as those for a standard 1031 exchange. A certain dollar amount may be distributed directly to you at the closing of the sale of the relinquished property if you know the exact amount needed for the acquisition of the replacement property.
Usually, the exact amount of equity needed for the purchase of the replacement property is unknown at this stage. One solution is to have the qualified intermediary (QI) hold all of the proceeds from the property sale and distribute the excess cash from the exchange account after the equity requirements for the replacement property have been determined. However, you will have to wait to receive the excess funds after you close on the replacement property. Once the QI releases the excess funds into your control, you will owe capital gains taxes on the amount.
A partial exchange is a bit more complicated than a standard exchange, so selecting your “exchange team” is important before beginning the sale process. Consult your accountant early on to understand the tax consequences of a partial exchange. You may have unrelated tax implications, such as income tax losses, that could be offset and could influence your exchange decisions.
Is A Partial Exchange Right For You?
Partially exchanging your home depends on your specific circumstances, as always. It is important to consider your need for quick cash and the subsequent tax consequences, which are based on the relinquished property’s cost basis and depreciation claims you have made.
To understand how a boot is created, let’s take a look at two examples. Assume you sold a property without a mortgage and a net profit of $350,000. Due to the fact that $50,000 cannot be reinvested into the new property, you will be taxed on the $50,000 at the capital gains tax rates listed above.
An example is when you sell a house for $400,000, but the mortgage is $200,000. Despite having a $175,000 mortgage, you reinvest the $400,000 on a replacement property. The difference between the two mortgages is $25,000, and that’s the amount of mortgage boot that’s taxable.
Partial 1031 Exchanges: What Are The Benefits?
A partial 1031 exchange may be beneficial for the following reasons:
The exchange must provide you with funds. Partial exchanges can increase your liquidity if you need funds from your 1031 exchange. It can be used for anything – vacations, property purchases, medical expenses, etc.
Replace the property with one with less leverage. Your replacement property may require you to remove some leverage/debt. Let’s say you relinquish a property worth $300,000 with a mortgage worth $20,000. If you 1031 exchange the $300,000 for the replacement property, you will have to pay taxes on the $20,000 as well.
Partial 1031 Exchanges: What Are the Cons?
There may be no benefit to doing a 1031 exchange if the boot equals or exceeds capital gains on the relinquished property. Basis and depreciation will determine how much you can depreciate. The tax treatment of a boot varies depending on how it was created, so you should consult a tax professional for clarification. A partial exchange could, if the boot is large enough, be as tax-effective as straight-selling the property if the boot is large enough.