Erin Crowley
Division manager, Asset Preservation Inc.
With the strength of our current market, investors in Colorado generally have significant capital gain when they sell real estate held for investment. Many, in addition, have little or no mortgage remaining on the property. Thus, the question arises: “May I put some cash in my pocket at closing and still perform an IRC 1031 exchange?” The answer is yes. This is called a partial exchange and is permitted under the Section 1031 of the tax code. Any cash that is pocketed at closing is considered “cash boot” and is likely to be taxable, so the investor also must determine whether an exchange still is beneficial, depending on how much of the sale proceeds are received by the investor.
What is a partial exchange? In a partial exchange, the investor decides to defer some capital gain taxes and also pay taxes owed on either cash proceeds received; or a reduction on the investor’s replacement property’s debt obligation. Both of these events result in the receipt of “boot,” which refers to any property received in an exchange that is not considered “like-kind.” (Cash boot refers to the receipt of cash. Mortgage boot is a term describing a taxpayer’s reduction in mortgage liabilities on the replacement property purchase compared to the mortgage on the relinquished property. Any personal property received as consideration is considered boot.)
When can cash proceeds be received? Cash proceeds can be received as follows:
- When the investor specifically instructs the closing officer to disburse a fixed dollar amount of the sale proceeds directly from the relinquished property closing; or
- After all identified property has been purchased or after the end of the exchange period (generally 180 days) if there are properties that have been properly identified but not purchased.
What are the requirements for full tax deferral in an exchange? If an investor intends to perform an exchange that is fully tax deferred instead of partially deferred, she must meet two specific requirements:
- Reinvest the entire net equity (net proceeds) in one or more like-kind replacement properties; and
- Acquire one or more replacement properties with the same or a greater amount of debt. (One exception to the second requirement is that an investor can offset a reduction in debt by adding cash to the replacement property purchase.)
Will the investor still benefit if he performs a partial exchange? As in any 1031 exchange, it is important to have a tax adviser review the investor’s specific situation and unique facts and circumstances.
In order to determine if an investor will benefit from a partial exchange, it is necessary to compare the amount of capital gain the investor would incur if no 1031 exchange is completed, with the amount of boot resulting from a partial exchange. If the boot is equal to or greater than the capital gain, there will likely be no benefit in doing a 1031 exchange. The investor will pay the same tax either way. Investors are taxed on the boot resulting from a partial exchange up to the full amount of the investor’s capital gain.
Example: An investor is selling a commercial building for $5 million. There is no mortgage debt on the property. The investor’s adjusted basis in the property is $3 million. If the investor does not exchange, there will be a capital gain of $2 million (less closing costs), which will be taxable unless the investor has other offsets. If the investor elects to complete a partial exchange and cashes out $1 million at closing and then purchases a repayment property with all cash for $4 million – the investor will still benefit from the exchange since the tax on the $1 million boot is less than the tax on the investor’s total capital gain of $2 million.
The bottom line is if the boot is greater than the amount of the capital gain, then it is generally not recommended to do a 1031 exchange. If the boot is less than the amount of capital gain, the investor will likely benefit by obtaining partial tax deferral.
