A 1031 exchange is one of the best tax strategies in a real estate investor's toolbox. Selling a property, especially one that you've held for a long time or sold at a substantial profit, can be an expensive event tax-wise. A 1031 exchange allows you to defer all taxation by reinvesting the sale proceeds in a new property.
However, what if you need to use some of your sale proceeds? Let's say that your kid's tuition bill is due, or that you want to buy a new car.
Fortunately, a 1031 exchange isn't an all-or-nothing deal. You can choose to take some money off the table upon the sale of an investment property while still deferring the majority of your tax liability. With that in mind, here's a rundown of what you need to know about partial 1031 exchanges and how they can be useful to your investment strategies.
What is a 1031 exchange?
A 1031 exchange (also commonly referred to as a "like-kind exchange") is a tax strategy for real estate investors that allows for the deferment of any taxes the investor might owe on the sale of an investment property.
When you sell an investment property, there are two potential types of taxes you might have to pay. If your net selling price is more than you paid to acquire the property, you'll have to pay capital gains tax. As long as you owned the property for more than a year, this portion of the sale will be taxed at favorable long-term capital gains rates (currently 15% for most taxpayers).
In addition, there's a tax known as depreciation recapture. One of the year-to-year benefits of owning rental properties is the ability to claim depreciation deductions. These deductions can dramatically reduce your taxable rental income. However, once the property is sold, the cumulative depreciation you've claimed is treated as ordinary taxable income.
As you can imagine, these can combine to produce a hefty tax bill.
Consider this scenario: Let's say that you bought a duplex for $150,000 10 years ago and that you just sold it for a net proceeds of $250,000. During your 10-year ownership period, you claimed depreciation expense of about $54,500. This means that you have a $100,000 long-term capital gain and $54,500 in depreciation recapture that is treated as ordinary income. Based on a 22% marginal tax rate, you can expect to pay nearly $27,000 in taxes upon the sale.
A 1031 exchange allows you to defer all taxation by using the proceeds from the sale to invest in another property. By doing so, you're effectively transferring the cost basis and depreciation from your original property to a new one (known as the replacement property). If you eventually sell the replacement property, you'll have to pay the taxes, but if you don't sell (or if you complete another 1031 exchange in the future), you can defer taxation indefinitely.
The 1031 exchange requirements to defer all of your taxes
In order to defer all of your taxes when completing a 1031 exchange, there are three financial requirements that need to be satisfied, in addition to the other rules and procedures involved with a 1031 exchange.
- First, the replacement property's purchase price must be equal to or greater than the sale price of your original property. If you sell a duplex for $300,000, you must spend this much or more on a replacement property or properties.
- Second, you must carry as much debt on your replacement property as you had on the original property at the time of the sale. In other words, if you had a $150,000 mortgage balance remaining when you sold your original property, your new property must be purchased with at least $150,000 in debt financing.
- Finally, your equity in the replacement property must also be equal to or greater than the equity you had in the original property. As an example, if you sell a $500,000 property with a $200,000 mortgage and buy a $800,000 property with a $600,000 mortgage, you are in compliance with the first two rules, but your equity in the property will have declined from $300,000 to $200,000 as part of the exchange.
Here’s another hypothetical: Let's say that you sell an investment property for $300,000 and that you owed $150,000 on its mortgage at the time of the sale. If you were to buy a replacement property for $400,000 with a $250,000 mortgage, it would satisfy all three requirements and you could use your 1031 exchange to completely defer taxation on the transaction. On the other hand, if you bought a replacement property for $400,000 in cash (no mortgage), you couldn't defer all of your taxes because the exchange didn't meet the debt requirement even though the other two were satisfied. But don't panic, this does not invalidate the whole 1031 exchange.
A partial 1031 exchange can allow you to defer some of your taxes
Contrary to popular belief, a 1031 exchange isn't an all-or-nothing tax strategy. It's possible to buy a property for less than the original property's sale price or with a mortgage that is less than the balance owed at the time of the sale, and to defer some taxes.
Specifically, if the net sale price of the original property is greater than the purchase price of the replacement property, the difference is known as "boot" and is indeed taxable. You can choose to receive proceeds upon closing of the original property's sale, or upon the conclusion of the entire exchange process.
Similarly, if the mortgage on the replacement property is less than the outstanding mortgage on the property you sell, it is treated the same way. Whichever form it's in, the portion of the proceeds that is considered "boot" is subject to capital gains and depreciation recapture taxes if they apply. The remaining net proceeds that are reinvested will be tax-deferred.
In other words, if you own a property free and clear and you sell it for $220,000 (net), and you plan to complete a 1031 exchange and acquire a new property for $200,000, the $20,000 difference will be taxable.
Or, let's say that you sell a property for $250,000 and that you have a $150,000 mortgage balance. If you acquire a replacement property for $250,000 but with a $130,000 mortgage, you'll also have $20,000 in taxable boot.
Why might you want to complete a partial 1031 exchange?
There are many potential reasons to complete a partial 1031 exchange, but because of the financial rules of 1031 exchanges, they can all be broken down into two main categories.
First, a partial 1031 exchange could make sense if you need some money from the sale. As an example, if you sell a property for $350,000 and need $50,000 to cover your child's tuition, you could acquire a new property for $300,000 and only realize a $50,000 gain.
Second, a partial 1031 exchange could make sense if you want to lower your leverage. Let's say that you sell a property for $400,000 that has a $50,000 mortgage balance. If you want to own your next property free and clear, you could complete a partial 1031 exchange by purchasing another property for $400,000 in cash and paying tax on the $50,000 boot.
Professional assistance is especially important in a partial exchange
The mechanics of a 1031 exchange are complex enough when it's a complete deferral of taxation. With a partial 1031 exchange, it can be even more complicated. In addition to the required exchange facilitator or qualified intermediary, I strongly suggest that you consult a tax attorney or other qualified professional to help assess your tax liability after your partial 1031 exchange occurs.