Partial Exchanges

• Some taxpayers believe that they must “buy up” (spend all the equity from their sale by purchasing a more expensive property) to defer taxes with a 1031 exchange.

• However, taxpayers may choose to defer some, but not all, capital gain taxes in order to receive some cash immediately or to reduce any new mortgage on the replacement property.

• This cash in hand is referred to as “boot,” which impacts tax obligations.

• Cash can be taken out at the time of the closing of the sale of the property by directing a certain amount to be paid directly to the taxpayer. The remainder of the equity would then be placed with the qualified intermediary for the 1031 exchange.

• After buying all identified properties or at the end of the maximum exchange period (180 days), any remaining cash would be returned to the taxpayer.

• To fully defer all taxes, taxpayers must reinvest all net equity into a replacement property with a purchase price that equals or exceeds the amount the relinquished property sold for. New debt may be incurred or additional cash paid to purchase this replacement property.

• If the taxable “boot” exceeds the capital gain, a 1031 exchange will not be beneficial. For example, if the amount of cash in hand (cash received at the time of the sale of the relinquished property) is more than the capital gain, an exchange will not defer taxes. It is critical to consult with a tax or legal advisor before proceeding with any sale of relinquished property. Or if the amount of non-qualifying replacement real estate is more than the capital gain, an exchange will not defer taxes unless the exchanger is adding cash and/or financing to increase the level of investment enough that the amount of qualifying property exceeds the exchanger’s basis in the relinquished property.

• Partial exchanges provide an attractive alternative for investors who want to defer some taxes while receiving some cash immediately at the time of the sale. Determine your current adjustable basis for income tax purposes before pursuing this strategy.