Sometimes the benefits of using the proceeds from the sale of one real estate holding to purchase a new real estate investment through a 1031 Exchange are too big to pass up. Sometimes life gets in the way.
That’s where a partial 1031 Exchange comes in with an opportunity to take cash out or reduce leverage while still being able to defer taxes or diversify holdings as in a traditional 1031 Exchange.
In other words, it’s possible to access the long-term benefits of a 1031 Exchange without ignoring short-term needs.
An Overview of 1031 Exchanges
When selling a real estate investment holding, individuals face potential capital gains and depreciation recapture taxes. In a traditional real estate transaction in which the sale property was held for more than a year, an investor can expect to pay as much as 40% in various taxes.
Those taxes can be deferred through a 1031 Exchange, but rules require that 1) the new property must be of equal or greater value than the sale price of the original property and 2) all sales proceeds must be reinvested in the new property and 3) the mortgage on the new property must be an equal or greater than the final mortgage balance on the original property – or cash from outside the exchange can be added to offset this mortgage requirement.
What is a Partial 1031 Exchange?
With a partial 1031 Exchange, it’s possible to take cash out or reduce mortgage liability by not fully reinvesting the proceeds from the sale of the original property into the new property. In this case, the investor will incur some taxes at the sale and defer other taxes as part of reinvesting the remaining proceeds into the new purchase.
The proceeds not reinvested in a partial 1031 Exchange are called “boot” and the boot can be in the form of cash out or lower mortgage liability.
Two examples can help clarify scenarios where an individual might pursue a partial 1031 Exchange.
Taking Cash Out in a Partial 1031 Exchange
By way of example, let’s presume that you purchased a rental unit 10 years ago for $300,000 and recently sold it for $500,000. Over the years, you claimed $100,000 in depreciation deductions.
Setting aside details related to improvements and sales costs, your tax liability at time of sale could be as high as 40% of your taxable gain which would be based on a $500,000 sales price less your adjusted cost which is calculated by subtracting your claimed depreciation expenses of $100,000 from your original purchase price of $300,000 purchase price as follows:
Potential Tax Liability: 40% X ($500,000 - $200,000 adjusted basis) or $120,000
While it’s possible to defer the $120,000 of potential owned taxes through a 1031 Exchange, you also have the option of pulling a portion of the funds out from the sale – provided you are willing to pay the taxes on funds not used in a 1031 Exchange. By taking cash from the proceeds, you will still be able to complete a full tax deferral on the remaining funds used to complete a 1031 Exchange or, in this case, what is called a partial 1031 Exchange.
This may surprise you, but our general recommendation to our clients is to always consider taking some funds out of an exchange for the following reasons:
- If you need the funds for an important use that is more valuable than reinvesting funds in a 1031 Exchange e.g., paying for your children’s education, covering medical expenses, etc.
- To enjoy some immediate benefit from working many years to accumulate appreciated equity
I often share the story of a couple that we worked with who had worked very hard over many years to accumulate a large equity position in a rental portfolio that they were growing tired of managing. I asked them to consider investing some of the funds from the sale of their properties to complete a “bucket list” event from their list. A couple of weeks later they told us they had decided to go on a first- class trip to Africa with some of the funds. While they had to pay taxes on funds used for the trip, they told us that the decision to use some of the funds resulted in a highly rewarding and memorable event in their lives which would not have been possible without tapping into their accumulated equity.
Finally, be sure to seek advice from your tax advisor when considering a partial 1031 Exchange. You may discover that you have items in your overall financial profile such a tax loss carry forward that could offset some of the tax liability.
A partial 1031 Exchange could be a potential path toward improving your current situation while maintaining a good balance with your long-term investment focus.
Please contact us today for more information. You can also schedule some time directly on Paul's calendar, here.
Disclosure: DSTs, like all real estate, have risks, including illiquidity, potential for loss of property value, costs and expenses that could offset the benefits associated with tax deferral, and reduction or elimination of monthly cash flow.
Disclaimer: There is no guarantee that any strategy will be successful or achieve investment objectives. All real estate investments have the potential to lose value during the life of the investments. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please be aware that this material cannot and does not replace the Memorandum and is qualified in its entirety by the Memorandum.
This material is not intended as tax or legal advice so please do speak with your attorney and CPA prior to considering an investment. This material contains information that has been obtained from sources believed to be reliable. However, FGG1031, First Guardian Group, LightPath Capital, Inc., and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) and 1031 Exchange properties. These include, but are not limited to, tenant vacancies, declining market values, potential loss of entire investment principal.
Past performance is not a guarantee of future results: potential cash flow, potential returns, and potential appreciation are not guaranteed in any way and adverse tax consequences can take effect. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All financed real estate investments have a potential for foreclosure. Delaware Statutory Trust (DST) investments are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits.
IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, you should consult your tax and legal professional for details regarding your situation.