Can You Do a Partial 1031 Exchange and What You Need to Know

A partial 1031 exchange can be a valuable tool for investors looking to minimize taxes on their real estate sales. This type of exchange allows you to swap one property for another of equal or greater value, deferring taxes on the gain.

You can do a partial 1031 exchange if you sell a property that is part of a larger portfolio, for example, if you sell one of three rental properties. This is a common scenario for investors with multiple properties.

To qualify for a partial 1031 exchange, the replacement property must be of equal or greater value than the property being sold. The IRS requires a minimum of 95% of the relinquished property's value to be replaced with a like-kind property.

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A 1031 exchange is a tax-deferral strategy that allows you to defer capital gains taxes on the exchange of like-kind properties. Named after Section 1031 of the Internal Revenue Code, this provision is widely utilized in real estate and other asset-heavy industries.

In a 1031 exchange, you can sell an investment property and use the proceeds to buy a similar property, deferring the tax on the capital gains from the sold property. This essentially means that if you sell an investment property and use the proceeds to buy a similar property, the tax on the capital gains from the sold property can be deferred.

Like-kind property is a key concept in 1031 exchanges, referring to a tax-deferral strategy employed by investors and businesses in the United States. Under Section 1031 of the Internal Revenue Code, taxpayers can exchange certain types of property for another without incurring immediate capital gains taxes.

The properties involved must be of the same nature or character, but they don't necessarily have to be identical, such as exchanging a commercial property for another commercial property, or a piece of land for another piece of land. This flexibility allows investors to adjust their portfolios without triggering taxable events, thereby preserving capital for further investment.

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To perform a partial 1031 exchange, you'll need to follow the IRS rules and regulations, just like a typical exchange process.

You can request to receive a portion of the sale proceeds at the closing of the sale or anytime after that, but the exact amount needed to purchase the replacement property is usually unknown at that point.

A good solution is to hold the realized sale proceeds in escrow until the price of the replacement property is determined.

You'll need to wait until the close of your replacement property before receiving the excess funds from your facilitator.

Once the qualified intermediary releases the excess funds into your possession, you're automatically liable for paying taxes on the received funds.

For another approach, see: Proceeds of the Viatical Settlement Contract

A partial 1031 exchange can still defer a portion of your taxes, but it depends on the specifics of your transaction. You can dispose of one or more relinquished properties and acquire one or more replacement properties as part of a single 1031 Exchange transaction.

You may end up with cash left over, known as cash boot, after completing your 1031 Exchange. This can happen if you trade down in value or don't trade equal in value.

A partial 1031 Exchange can defer a portion of the depreciation recapture and/or capital gain income tax liabilities, but this depends on the circumstances. You should consult with your tax advisor to determine if completing a partial 1031 Exchange will still defer sufficient taxes in order to justify the 1031 Exchange.

In a partial exchange, you'll pay potentially recognized gain on the cash proceeds received or a partial reinvestment on the replacement property mortgage compared to the relinquished property mortgage.

Discover more: Partial 1031 Exchange Boot Example

A Structured Sale can be a lifesaver in a failed 1031 Exchange, allowing you to receive your exchange proceeds in the form of an annuity contract instead of a taxable cash distribution.

This integrated structure can be added to your 1031 Exchange Agreements before the sale of your relinquished property, giving you control over when you pay your taxes.

With a Structured Sale, you can defer paying capital gain taxes over a period of time you choose, even if your 1031 Exchange fails.

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A Structured Sale can be a lifesaver for companies facing financial distress. It allows you to receive your 1031 Exchange proceeds in the form of a Structured Sale annuity contract instead of a taxable cash distribution.

This integrated structure can be set up prior to the close of your relinquished property sale transaction, giving you peace of mind knowing you have a plan in place. The Structured Sale can be integrated into your 1031 Exchange Agreements.

You can continue to defer the payment of your capital gain taxes over a period of time that you choose, even if your 1031 Exchange has failed. This can be a huge relief for companies struggling to stay afloat.

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You can complete a partial exchange by purchasing less than you sold, creating a taxable event. This is true even if you use all cash proceeds in the purchase.

The net sale of your relinquished property is $1,000,000, but you buy replacement property for a net $900,000. This shortfall is typically due to taking on less indebtedness for the replacement property.

A taxable shortfall of $100,000 is created, which is the difference between the sale and purchase prices. This shortfall is a key aspect of the exchange.

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You can take cash out of a partial 1031 exchange in a few specific situations. At the closing table of your sale, you can receive up to $100,000 in cash, as seen in Example 1.

This cash is considered taxable and must be accounted for in your exchange documentation. In the example, the exchange portion is $900,000, and the cash out is $100,000.

You can also take cash out after day 45, but only when you've finalized the purchase of all replacement properties and have funds left in your account. This is another opportunity to receive cash, but it's essential to have a clear agreement with your Qualified Intermediary (QI) outlining this arrangement.

If you don't use the cash by day 180, you can take it on the first business day after this date. Again, your QI agreement should explicitly spell out these cash-out options to avoid any delays.

Here are the cash-out opportunities in a summary:

A partial 1031 exchange may not make sense if the taxpayer will start deferring gain only when they have acquired replacement property, the value of which exceeds their basis in the relinquished property.

You'll end up paying a qualified intermediary to accommodate the 1031 exchange, identify and acquire replacement property, only to discover that the tax triggered on the boot may be close to the tax due if no exchange was initiated.

Equity and mortgage boot are taxable because the Internal Revenue Service considers them benefits received.

Additional cash always offsets debt, but additional debt does not offset cash.

You should seek the input of your CPA to determine the tax due in a sale without a 1031 exchange before considering a partial 1031 exchange.

A qualified intermediary is not required to challenge the taxpayer's intent to pay their fee, which raises questions about whose interest they are serving.

The tax due on cash received or debt not replaced is the key to determining whether a 1031 exchange makes sense in your situation.

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A partial 1031 exchange can be done in various ways, but it's essential to understand the tradeoffs involved.

You can take cash out of the exchange, purchase less than you sold, or both.

It's possible to complete a partial 1031 exchange that allows you to either take cash out, purchase less than you sold, or both.

However, completing a partial exchange creates a tax liability you will want to thoroughly understand before moving forward.

You'll want to determine if it's a good fit for your personal and financial goals before proceeding with a partial 1031 exchange.

This means considering the tax implications and whether they align with your overall financial strategy.

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