A 1031 exchange is based upon the premise that the replacement property acquired is of equal or greater value than the property sold. A pervasive misconception regarding 1031 exchanges is that you MUST reinvest all exchange proceeds and debt, it is not required however it is encouraged in order to optimize the tax deferral potential. Partial 1031 exchanges are when the taxpayer does not use all the net equity and debt retired in the new property. Cash received (equity boot) or debt not replaced (mortgage boot) is taxable. Given the taxpayer’s intent to receive cash, the best time to receive it is at the initial closing. An alternative is to do a post-exchange refinance accessing cash, not paying the tax by increasing debt.
Critical Error to Avoid in a Partial 1031 Exchange
Partial exchanges are popular, but in some cases a 1031 exchange may not make sense. The taxpayer will start deferring gain only when he has acquired replacement property, the value of which exceeds his basis in the relinquished property. If not, the tax triggered on the boot may be close to the tax due if no exchange was initiated. In other words, you pay the qualified intermediary to accommodate the 1031 exchange, identify and acquire replacement property all to discover later that the tax triggered on the cash received or debt not replaced is not much different if the tax was paid on the sale without a 1031 exchange.
Equity and mortgage boot are taxable given the Internal Revenue Service considers them benefits received. Cash received or debt not replaced on the new property is not equal to or greater than on the old property changes the taxpayer’s economic position. Additional cash always offsets debt, but additional debt does not offset cash. The reason for the tax deferral is that the taxpayer is reinvesting all their net equity and the replacing the debt retired in the replacement property; consequently, no gain is recognized.
CPA Input
When considering a partial 1031 exchange, seek the input of your CPA to determine the tax due in a sale without a 1031 exchange. Next, what is the tax due on cash received or debt not replaced? This will save the angst and gnashing of teeth wondering why your qualified intermediary did not suggest that a 1031 exchange may not make sense. The qualified intermediary is not required to challenge the taxpayer’s intent to pay their fee. This should give rise to whose interest the qualified intermediary is serving. Perhaps it is time to find another qualified intermediary.
What is a 1031 Exchange?
For those not familiar with a 1031 exchange, the Internal Revenue Code Section allows taxpayers to defer the federal and state capital gain and depreciation recapture taxes on the sale of real property held in the productive use of a business or investment when “like-kind” property is replaced. Real property can be exchanged for any real property. There are many rules to be followed with one of those to use a qualified intermediary to facilitate the 1031 exchange. Generally, anyone who has acted as the agent of the taxpayer in the previous two years is disqualified from being the taxpayer’s qualified intermediary. There are exceptions.
The typical exchange is initiated by individuals, husband and wives, trusts and companies on transactions where the old property sells for $300,000 or less. Primary residences, partnership interests, indebtedness, stocks and securities and inventory are not eligible for the tax deferral. Farms and ranches are eligible and should the farm house represent the primary residence, Section 121 covers the house and the land is sold in a 1031 exchange deferring the recognized gain on the land.
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