The Partial 1031 Exchange: When Taking Some Cash Out Is the Right Call

The usual advice about 1031 exchanges is absolute: reinvest every dollar, replace every dollar of debt, and defer everything. That advice is correct if the goal is maximum deferral. It is not the only sensible goal.

A partial exchange lets you defer tax on most of your gain while deliberately taking some cash out and paying tax only on that portion. For owners who need liquidity, want to reduce risk, or simply cannot find enough good replacement property, it is often the most rational choice.

What is a partial 1031 exchange?

An exchange in which you do not reinvest all of the net proceeds, or do not replace all of the debt, and accept tax on the difference.

The difference is called boot. It is taxable in the year of the exchange, but only to the extent of your realised gain. Everything that is reinvested stays deferred.

A partial exchange is not a failed exchange. It is a successful exchange of part of the value, combined with a taxable sale of the rest.

How is the cash taxed?

Boot is taxed at the rates that apply to the gain it represents, and on long held property the first slice is usually depreciation recapture.

That means cash taken out of an exchange on an old rental is typically taxed at up to 25 percent federally before long term capital gains rates apply, plus the net investment income tax where relevant, plus state tax. Owners who expect 15 or 20 percent are often surprised.

Boot cannot be taxed on more than your total gain. If your gain is 300,000 dollars and you take 400,000 dollars of cash, only 300,000 dollars is taxable.

When does a partial exchange make sense?

You need cash for a real purpose. Retirement, paying down other debt, helping family, or simply holding a reserve. Paying tax on what you need, while deferring the rest, is usually better than either paying tax on everything or borrowing awkwardly.

You cannot find enough good replacement property. Buying a property you do not want, at a price you would not otherwise pay, to avoid tax on the last few hundred thousand dollars is frequently a worse outcome than paying the tax.

You want to reduce leverage. Owners approaching retirement often want less debt. Replacing less debt creates mortgage boot, which is taxable, but some owners decide that lower risk is worth the tax.

Your income is low this year. If a portion of the gain falls into lower tax brackets, taking some boot in a low income year can be efficient.

How should a partial exchange be structured?

Carefully, and in the right order. The main principles:

• ›Take cash at the end, not the start. Cash received before or during the exchange from the relinquished sale can be boot and can create other problems. Plan the amount and have it released correctly under the exchange agreement.
• ›Know the one way rule. Adding your own cash offsets debt relief. Taking on more debt does not offset cash you receive. If you are going to fall short on one side, being short on debt is often easier to manage.
• ›Model the tax in advance. Ask your CPA to calculate the boot, the character of the gain, and the state tax so the cash you receive is not a surprise.
• ›Keep replacement value realistic. You still need to acquire replacement property within the deadlines to defer the rest.

Is there a better way to get cash?

Sometimes. A common alternative is to complete a full exchange and later refinance the replacement property to take out cash. Loan proceeds are not taxable, so equity can be released without boot.

That approach depends on financing being available and affordable, adds debt and interest cost, and should be separated clearly from the exchange rather than arranged at the purchase closing. For owners who want to reduce debt rather than add it, a partial exchange may be more appropriate.

How can you place an awkward remainder instead?

Sometimes the problem is not a desire for cash but a mismatch in property prices. You sold for 1.4 million, the building you want costs 1.2 million, and the 200,000 dollar remainder has nowhere obvious to go.

In those cases, fractional replacement property such as a Delaware Statutory Trust interest can absorb a specific amount, allowing the remainder to be reinvested rather than taxed. DST interests are securities available to accredited investors only and carry illiquidity and costs, but they are frequently used exactly for this.

What does a worked example look like?

Suppose you sell a rental for 1.5 million dollars with no mortgage. Your adjusted basis is 500,000 dollars, so your gain is 1 million dollars, including 300,000 dollars of accumulated depreciation.

You decide to reinvest 1.3 million dollars and keep 200,000 dollars in cash. That 200,000 dollars is boot. Because depreciation recapture is taxed first, all 200,000 dollars is likely taxed at up to 25 percent federally, around 50,000 dollars, plus state tax and potentially the net investment income tax.

The remaining 800,000 dollars of gain stays deferred in the replacement property. You have paid tax on exactly the cash you chose to take, and nothing more.

Compare that with a full taxable sale, where tax would be due on the entire 1 million dollar gain. For an owner who needs 200,000 dollars, the partial exchange is dramatically cheaper.

What to do first

Decide how much cash you actually need, and why. Then ask your CPA to model the tax on that amount, and compare it with the alternatives: a full exchange with later refinancing, or a full exchange using a fractional replacement to absorb the remainder. The right answer is usually clear once the numbers are side by side.

Nothing here is tax, legal or investment advice. Every situation depends on your facts. Confirm your plan with your CPA before acting.