For many investors, one of the major benefits of a commercial real estate investment is the tax advantages that come with it. One of the most prominent tax advantages is the ability to participate in a program known as a 1031 Exchange.
In this article, we are going to describe the 1031 Exchange program generally and one type of exchange – known as a partial exchange – specifically. We will describe what it is, how it works, why it is beneficial, and the potential risks to be aware of. By the end, readers will have the information needed to determine if a partial 1031 Exchange is a potential tax savings option in their own investment strategy.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. In this line of business, we are well versed in helping investors place 1031 Exchange money. If you are an Accredited Investor interested in a 1031 Exchange and would like to learn more about our current opportunities, click here.
What is a 1031 Exchange?
In order to understand what a 1031 Exchange is, it is helpful to describe a typical scenario where one could be used.
Imagine an older married couple. In their younger years, they had successful careers and used some of their earnings to purchase a small retail center for $1MM. Over many years, the market grew and rents increased, both of which made the property move valuable. By the time they are ready to sell it, they believe they can get $2MM from a potential buyer. In the most simplistic sense, the difference between the original purchase price ($1MM) and the potential sales price ($2MM) is considered to be a “gain” and it is taxable. Upon sale, the couple will owe capital gains taxes on this $1MM gain, which is something they may not be prepared for. One of the ways they can defer taxes on this gain is to complete a 1031 Exchange.
So, with this scenario in mind, a 1031 Exchange is a program that allows investors to defer taxes on their gain as long as they reinvest their sales proceeds into a “like kind property” within a certain time period. According to 1031 Exchange rules, which are defined by the IRS, the investor must identify their replacement property within 90 days of the sale of their old property (the “relinquished property”) and close on it within 180 days.
Partial 1031 Exchange Definition
In order to obtain complete tax deferral, there are a number of rules that investors must comply with when completing a 1031 Exchange. As it relates to the topic of this article, one of the most important is that real estate investors must reinvest all of their sales proceeds into the new property. If they don’t, the portion not invested is known as “boot” and that part of the gain is taxable.
When all proceeds are not invested, it is known as a partial 1031 Exchange.
How a Partial 1031 Exchange Works
To further explain a partial 1031 Exchange, let’s continue the example above to demonstrate how it works.
Remember, our married couple has a small retail property for which they paid $1MM and are going to sell for $2MM. For the sake of this example, assume that the property has a $500,000 loan against it at the time of sale, which means that the net proceeds at the time of sale are $1.5MM. There are two potential ways to create a partial 1031 Exchange out of this scenario.
The first is to buy a replacement property that is less expensive than the net proceeds obtained. For example, suppose that the married couple purchases a new investment property for $1.3MM. The $200,000 difference is considered to be “cash boot” and this portion of the transaction is taxable.
The other scenario has to do with debt. Suppose that the couple purchase a new 1031 Exchange property for $3MM, but takes on $2MM in debt. The $1MM in required equity is less than the $1.5MM in net sale proceeds. The $500,000 difference is taxable.
To sum this point up, 1031 Exchange rules state that if there is any difference between the amount of net sales proceeds received and total amount invested in the replacement property, it is considered to be a partial 1031 Exchange and any difference between net sales proceeds and those invested in the new property is considered to be “boot” and it is taxable.
Benefits and Risks of a Partial 1031 Exchange
Like many things in real estate investment, there are both benefits and risks to completing a partial 1031 Exchange.
For investors, there are two major benefits to a partial 1031 Exchange, cash and reducing debt levels.
In the first scenario, investors are able to take cash out of a property. In the first scenario described above, the married couple is able to take their $1.5MM in proceeds and reinvest $1MM into the new property. The $500,000 difference is cash that goes into their pocket (less after taxes) to be used for whatever they wish. Perhaps they want to buy a house for their children or pay for college for their grandchildren.
As a general rule, less debt on a property means that it is a somewhat safer, more stable investment scenario. So, a partial exchange could be used to reduce the amount of debt on the replacement property in the like kind exchange. For example, suppose that the $1.25MM in our example is used to purchase a replacement property with a market value of $1.5MM. In this scenario, there is $250,000 in debt on the property, which is less than the amount in the sale of the relinquished property.
The primary downside to a partial 1031 Exchange is taxes. In the scenario above where the couple walks away with $500,000 in cash, they will have a tax liability that must be paid. The exact amount is somewhat dependent upon their own individual income tax rate, but it could be in the 15% – 30% range.
The calculation of an investor’s tax liability can be complex and difficult. For this reason, it is always a good idea for individuals to work with a qualified tax advisor, with expertise in the tax code, to make sure that all aspects of their investment activity are accounted for when completing their annual tax return.
Understanding if a Partial Exchange is the Right Decision
There are a number of different types of 1031 Exchanges that investors can complete. In addition to a partial exchange, investors could complete a reverse exchange, delayed exchange, or construction exchange. The circumstances under which an investor would choose one over any of the others are unique to each individual financial situation. Factors for each individual to consider are things like: investment timeline, capital needs, income level, property cost basis, long term investment goals, and what they plan to do with the exchange proceeds.
Again, this decision can be complex for each individual taxpayer. For this reason, it is a best practice to work with a qualified CPA or tax expert with detailed knowledge of internal revenue code (IRC) rules to help make the best decision for each individual.
Understanding the Role of the Qualified Intermediary
In addition to the use of a CPA, it is also a best practice for 1031 Exchange investors to utilize the services of a qualified intermediary – QI for short. A Qualified Intermediary is an expert in 1031 Exchange rules and they work on behalf of investors to make sure that all exchange funds are handled properly and that all necessary rules are followed to minimize tax liability to the extent possible.
Summary and Conclusion
In a 1031 Exchange, investors can defer capital gains taxes on the profitable sale of a property held for investment purposes as long as they reinvest the proceeds into a new property that is considered to be “like kind.” For example, an apartment building is considered to be like kind to an office building.
To achieve full tax deferment, investors must purchase a property of equal or greater value and must reinvest 100% of their net sales proceeds. If they don’t, it is considered to be a “partial 1031 Exchange.”
In a partial 1031 Exchange, any cash or personal property received by the investor is taxable.
The benefit of a partial 1031 Exchange is that it allows investors to take cash out of the deal and/or potentially reduce the leverage used to purchase a new rental property.
The downside is that there are tax consequences in the sense that there is a tax bill to be paid. Calculation of the tax liability is unique to each investor so it is best handled by a tax professional.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.