I often come across investors nagging about losing all their proceeds in a 1031 exchange and having no cash for immediate need. Undoubtedly, a 1031 exchange is the most profound tax strategy a real estate investor could think of. Selling an investment property could be a costly affair tax-wise. A 1031 exchange shoves this burden off the investor’s shoulders by letting them defer all taxation if they choose to reinvest the sale proceeds in a new investment property.
However, what if you want to keep some cash from your sale proceeds for later? It could be anything – medical expense, another real estate investment, short-term financial crunch, or a vacation you had planned years ago. Or just that you don’t find reinvesting the entire proceeds in the new property worthy. Will you lose your opportunity to defer capital gain taxes?
To your good luck, a 1031 exchange doesn’t work like that. You can sweep some cash off the table while still deferring the majority of your capital gain taxes. Will it be considered as a 1031 exchange then? Yes, a partial 1031 exchange. You see, it’s not a myth; you can take out some cash from your sale proceeds and still defer capital gain taxes. In the next few paragraphs, I’ll try to explain through examples how can you defer all your capital gain taxes, and how does a partial 1031 exchange work?
1031 Exchange Tax-Deferral Strategy:
A 1031 exchange or a like-kind exchange is a tax strategy that lets real estate investors defer any taxes they owe on the sale of their investment property. On selling an investment property, you might be liable to pay two potential taxes. If the selling price of your investment property is more than the amount you paid to acquire it, you’ll need to pay the capital gain tax. When you own a property for more than a year, the capital gain is taxed at favorable long-term rates (which, at the moment, is 15% for most taxpayers).
Another tax you may need to deal with is depreciation recapture. The biggest perk of owning rental properties for a long duration is the opportunity to claim depreciation deductions. These deductions can significantly reduce taxable rental income. However, after the sale of the property, the overall depreciation you’ve claimed is taxed as normal income. A bit of calculation will tell you that this little income can combine and result in a hefty tax bill.
Let’s consider an example. Say you bought a duplex for $170,000 eight years ago, and you sold it for $280,000. Plus, during your eight years of ownership, you claimed a depreciation expense of about $48,500. So, you made a long-term capital gain of $110,000 and $48,500 in depreciation recapture, which will be treated as ordinary income. The marginal tax rate of 22% will make you lose nearly $32,000 in taxes upon the sale of your property. This is where you can make use of a 1031 exchange and save these dollars from taxes.
A 1031 exchange lets you defer all taxes on investing the entire proceeds from the sale of your old property (relinquished property) in a new property (called replacement property). On doing that, you effectively transfer the cost basis and depreciation from your old property to the new property. In case you sell out the replacement property, you’ll have to pay the taxes, but if you don’t, you can defer taxes.
Three Major Requirements of a 1031 Exchange:
To be able to make use of a 1031 exchange, you must fulfill three financial requirements, besides other rules and guidelines associated with a 1031 exchange.
- The value of the replacement property must be equal to or greater than that of the relinquished property. If you sell a duplex for $250,000, you must spend the entire proceeds in the replacement property.
- Both relinquished and replacement properties must have the same debt. Say, you had a $100,000 mortgage balance on your old property when you sold it. Now you must purchase the new property with at least $100,000 in debt financing.
- Your equity in the replacement property must be equal to or greater than the equity in the relinquished property. Let’s imagine you sold a $600,000 property with a $300,000 mortgage and bought an investment property worth $800,000with a $600,000 mortgage. By doing so, you will comply with the first two rules, but your equity in the property would decline from $300,000 to $200,000 as part of the exchange.
Let’s consider another example. Say, you sold an investment property for $400,000, and you owed $200,000 mortgage on the property at the time of the sale. If you bought a replacement property for $500,000 with a $300,000 mortgage, you would fulfill all three requirements and will be able to do 1031 exchange and defer all your taxes. However, if you bought a replacement property for $500,000 in cash with no mortgage, you wouldn’t be able to make use of a 1031 exchange and defer your taxes because your exchange didn’t meet the debt requirement even though you met the other two requirements. But still, there is no need to panic as this does not disqualify your whole 1031 exchange.
What Happens When You Save a Portion of Your Proceeds?
It’s a myth that a 1031 exchange is an all-or-nothing tax strategy. The value of your replacement property could be less than the original property’s sale price, or the mortgage on the new property could be less than the debt owed on the relinquished property. Yet, you could defer capital gain taxes.
When the sale price of the relinquished property is higher than the value of the replacement property, the difference in the cost is known as ‘boot,’ which is indeed taxable. You can receive the proceeds at the time of sale of the relinquished property, or when the exchange concludes.
Similarly, when the mortgage on the replacement property is less than that on your relinquished property, it results in a boot. No matter what, when you receive or save a portion of your 1031 exchange proceeds, it is considered ‘boot’ and is subject to capital gains and depreciation recapture taxes. Whereas, the remaining proceeds reinvested on the new property will be tax-deferred.
Let’s take a situation. Say, you own a property free and clear which you sold for $310,000 (net). If you do a 1031 exchange and acquire a new property worth $300,000, then the remaining $10,000 will be taxed as ordinary income.
Another example could be when you sell a property for $300,000 that has a mortgage of $150,000. Say, you reinvested $300,000 on the new property, but it has a $130,000 mortgage. In that situation, you will have to pay taxes on $20,000.
Why Should You Do a Partial 1031 Exchange?
There are a plethora of reasons why doing a partial 1031 exchange is a far better option than going for a normal 1031 exchange. Here are the two most important reasons:
First, a partial 1031 exchange is the best tax strategy if you need some money from the sale of your relinquished property. There could be a medical emergency or a vacation you need. Saving some money is always a better option. Say, you sold your investment property for $450,000, and you need to invest $100,000 somewhere else. In this case, you can buy a replacement property worth $350,000 and keep the remaining $100,000, which will be your gain and will be taxed normally.
Another reason for doing a partial 1031 is when you want to reduce your leverage. Say, you sold your relinquished property $350,000 that has a $30,000 mortgage. You can do a 1031 exchange on this property by reinvesting $350,000 on the new property and paying tax on the $30,000 boot.
Remember, no real estate investment is risk-free. It’s recommended that you consult your advisor or a 1031 exchange expert for a better understanding of the subject.
This article has been contributed by Alisha San.