Partial 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 would otherwise be due. But to have total gain deferral and pay no tax, you have to reinvest all of the proceeds from your sale into your replacement property. What can an investor do who is torn between reaping the full 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 enjoy some of the benefits of a 1031 exchange, while keeping some of the cash and deferring a portion of the tax. If you are considering a partial exchange, it’s very important to understand (1) what your partial exchange means in terms of tax ramifications and (2) 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, Chelsea 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, Chelsea identifies two choices: one rental house for $90,000 or a tract of land for $120,000. If Chelsea 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 make up the total price. With this choice, she will have $10,000 in mortgage boot that will be taxable. If Chelsea elects to purchase the second property using all of her proceeds and either obtaining a loan or investing new cash for the balance, she will have total tax deferral.
Secondly, it’s important for an exchanger to know when they are allowed to access 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 amount of cash they want will not be needed or used 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 way to receive cash is either to buy property that costs less than what you sold or, if financing is being used, to 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 at the proper time. The proper time is determined by the IRS Regulations that govern when the exchange funds can be sent to you. The Qualified Intermediary may only distribute your funds to you during the 180-day exchange period:
1. If prior to beginning the exchange, you stipulate in the Exchange Agreement with the QI that you are buying only one property that you specifically identify. When the acquisition of this one property is complete, even if it closes outside the 45 ID period, the QI can then release the leftover funds to you.
2. If you do submit an ID letter by the 45th day, but are beyond the Identification Period when you make purchase(s) of property (with the exception of one property outlined in example #1), 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 or #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 (as referenced or outlined in the Exchange Agreement) and would invalidate the whole exchange. Further, any QI that shows such a pattern of releasing funds improperly may find all the exchanges for which they have provided services could be considered tainted and potentially disqualified.
Partial exchanges are considered to be as valid as standard 1031 transactions and do not increase your chance of being audited. It's not all or nothing. 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.