1031 Exchanges: It's Not All or Nothing
One of the great attributes of a 1031 exchange is that it allows you to defer the taxes on the sale of investment property that otherwise would be due. But to get total gain deferral and pay no tax, you have to reinvest all of the proceeds from your sale into your replacement property. What should the investor do who is torn between the benefits of a 1031, but needs or wants to keep some of the cash? Is it all or nothing? The good news is that there is a way to correctly do a partial exchange, in which you keep part of the proceeds and defer part of the taxes due. If a partial exchange is chosen, it’s also important to know when you can have access to the cash.
First, there are two requirements in a 1031 exchange for total gain deferral. The exchanger must (1) buy replacement property that is the same price, or greater, than what was sold and (2) use all of the cash proceeds in the purchase. In tax terms, the investor must use or offset all of the “cash boot” (net proceeds) and “mortgage boot” (debt repaid) from the relinquished sale. Any amount of cash that is not used in the exchange, i.e. leftover after the replacement acquisition is complete, will be taxable (“cash boot”). Any debt not replaced when buying the replacement property, or not offset by additional cash invested in the replacement property, will also be taxable (“mortgage boot”.)
For example, Jane sells a property for $100,000 that has a $50,000 loan. At closing, she repays the bank and nets $50,000 in proceeds. In order to have full tax deferral, she would need to buy a property of equal or greater value, and reinvest all $50,000 in it. After searching, Jane identifies two choices: one rental house for $90,000 and land for $120,000. If Jane buys the first property, she can use her $50,000 toward the purchase, and obtain a loan for $40,000 or invest the same amount of new cash to get make up the total price. If she does this, she will have $10,000 mortgage boot that will be taxable. If Jane elects to purchase the second property by using all her proceeds and either obtaining a loan or investing new cash, she will have total tax deferral.
Secondly, it’s important for an exchanger to know when they can – and are allowed to--get the cash they would like to keep in a partial exchange. There are essentially two choices. If the exchanger knows through careful planning that the cash they want will not be needed to purchase the replacement property, they can have these funds disbursed directly to them at the relinquished closing by the closing attorney, title or escrow company that is handling the transaction. (For clarity, it is best to note on the closing statement the amount of cash being distributed to the exchanger.) Before ever making that determination, however, it is important for the exchanger to check with their tax advisor. If they elect to keep more cash than the amount of gain they would be deferring, there is really no benefit in doing an exchange.
The second option to receive cash is to either buy property that costs less than what you sold or, if financing is being used, get a larger loan than what was repaid at the relinquished sale. Then, after all replacement property is purchased, the Qualified Intermediary (QI) will still have cash leftover in your exchange account that they can disburse to you. If the exchanger knows through careful planning that the cash they want will not be needed to purchase the replacement property, they can have these funds disbursed directly to them at the relinquished closing by the closing attorney, title or escrow company that is handling the transaction. (For clarity, it is best to note on the closing statement the amount of cash being distributed to the exchanger.) Before ever making that determination, however, it is important for the exchanger to check with their tax advisor. If they elect to keep more cash than the amount of gain they would be deferring, there is really no benefit in doing an exchange.
It’s also important to know that the IRS Regulations govern when the exchange funds can be sent to you. The Qualified Intermediary may only distribute your funds to you in the 180-day exchange period if:
1.You close the replacement property within the 45-day Identification Period and do not submit a ID letter listing other properties, then the Qualified Intermediary can release the leftover funds to you on day 46.
2. You can stipulate in the Exchange Agreement with the QI that you are buying only one property. When the acquisition of the property is complete, even
if it is outside the 45 ID period, the QI can release the leftover funds to you.
3. However, if you do submit the 45 day ID letter, but are beyond the ID date when you make the purchase (with the exception of example #2), the QI is required to hold any leftover funds until 181 days after the relinquished sale. They cannot be released to you until that time.
Unless the conditions under #1 and #2 above are met, once the exchange has begun, the QI cannot release funds directly to the exchanger. Doing so would be a clear violation of the Regulations (referenced or outlined in the Exchange Agreement) and would invalidate the whole exchange. Further, any QI that shows such a pattern of releasing funds, may find all the exchanges they have provided services for tainted and potentially disqualified.
Partial exchanges are considered to be as valid as a standard 1031 transaction and do not increase your chance of being audited. With some careful planning, you can keep reap some of the benefits of a 1031, keep some of the cash and still comply with the IRS rules.