A 1031 Exchange allows a taxpayer to defer 100% of their capital gain tax liability. To do this, the exchanger must buy new Replacement Property equal to or greater than in value to the property sold and reinvest all of the proceeds from the sale of their old property.
But what happens if a taxpayer desires to purchase property lower in value or takes a portion of the cash from the closing of the sale and only invests a portion of their proceeds towards a 1031 Exchange? The good news is that these transactions still qualify for tax deferral under Section 1031 of the Tax Code. They simply become “partial” 1031 Exchanges where the taxpayer has a partially tax deferred transaction rather than deferring all of their taxes.
The portion of the exchange proceeds not reinvested is called “boot” and is subject to capital gains and depreciation recapture taxes.
If you fit into these scenarios:
- Taking cash at the sale of the Relinquished Property
Example: Randy is selling his rental townhouse for $1,000,000. At the close of escrow he wants to receive $100,000 to invest in the stock market and utilize his remaining funds for his 1031 Exchange. The $100,000 is not part of the tax deferred exchange. If the seller takes any cash from the sale, that amount becomes taxable boot.
- Buying Down in Value
Example: Randy is selling his rental townhouse for $1,000,000 and plans to utilize a 1031 Exchange to defer his taxes. However, he can only locate new property with a sales price of $800,000 that he desires to purchase. The $200,000 not reinvested into like kind property will be taxable boot.
but your goal is to defer 100% of your taxes, consider these potential solutions:
- Instead of taking cash from the sale of the old Relinquished Property, reinvest all the proceeds into new Replacement Property and then do a cash out refinance in a separate transaction after the closing. It is generally considered less risky to refinance the new Replacement Property (rather than the old Relinquished Property) through a separate post-closing transaction.
- Offset the gain on part or all of cash withheld with carryforward losses or expensing deductions for that tax year.
- If you cannot locate enough property that equals or exceeds the value of your old Relinquished Property, consider acquiring a fractional interest in additional Replacement Property, such as a beneficial interest in a Delaware Statutory Trust (DST). DSTs allow taxpayers to acquire small fractional interests in portfolios of properties such as multi-family housing, student housing, storage locker facilities, etc.
The important point is to not assume that you to need to pay taxes if you cannot locate property at the right values or have a need for cash. Everyone’s tax situation is different so always seek the guidance of a tax advisor prior to beginning your transactions.
Please feel free to reach out to one of your local IPX1031 experts to discuss the possibility and feasibility of your or your client’s next 1031 Exchange.
The best choice for your 1031.
IPX1031 is the largest and one of the oldest Qualified Intermediaries in the United States. As a wholly owned subsidiary of Fidelity National Financial (NYSE:FNF), a Fortune 300 company, IPX1031 provides industry leading security for your exchange funds as well as considerable expertise and experience in facilitating all types of 1031 Exchanges. Taxpayers’ funds are held in segregated accounts at large stable banking institutions in the United States. Our nationwide staff, which includes industry experts, veteran attorneys and accountants, are available to help you and your legal and tax advisors. For additional information regarding IPX1031 and questions on 1031 Exchanges, please review:
Boot in 1031 Exchanges
Refinancing Before and After Exchanges
Capital Gains Estimator
What is a 1031 Exchange?
IPX1031 Knowledge Center
Article courtesy of Investment Property Exchange Services, Inc.