When Does A Partial 1031 Exchange Make Sense?

For those unfamiliar with a 1031 Exchange NNN, the Internal Revenue Code Section 1031 allows a commercial real estate investor to defer federal and state capital gains and depreciation recapture taxes on the sale of real NNN property held in the productive use of a business or investment when replaced by “like-kind” property.

Partial 1031 exchanges are defined by an investor’s choice to not use all the net equity and debt retired in the new NNN property. The portion of the exchange proceeds that is not reinvested is called “boot,” (Cash received is “equity boot” or, debt not replaced is called “mortgage boot”) and are both subject to capital gains and depreciation recapture taxes. Note that the best time to receive cash is at the initial closing. (A clever alternative is to do a post-1031 exchange refinancing to obtain cash, or by not paying the taxes by increasing leverage.)

Since a partial 1031 exchange is more complex than a standard 1031 exchange, selecting a carefully vetted “transaction team” is key. Particularly, consult a CPA prior to the transaction to fully understand your tax consequences of a partial 1031 exchange. There may be unrelated tax implications, such as income tax losses that could be offset, which could influence the decision to engage in a partial 1031.

WHEN TO ENGAGE IN A PARTIAL 1031 EXCHANGE

If an investor knows the exact amount needed for acquisition of the replacement property, they can ensure that a specific dollar amount is distributed directly at the closing of the relinquished NNN property’s sale.

Usually, the exact amount of equity needed for the purchase of the replacement NNN property is unknown at the outset of the partial exchange. One solution is to have the qualified intermediary (QI) hold all of the proceeds from the sale of the relinquished property, and distribute the excess cash from the exchange account after the equity requirements for the replacement NNN property have been determined.

A partial 1031 exchange might make sense if the investor needs some cash for use after the transaction. E.g., relinquish a property for $6,500,000 to cover the need for $500,000 for the replacement property’s improvement by acquiring a HOT replacement property for $6,000,000 and realize a $500,000 taxable gain!

A partial 1031 exchange may also work if an investor wants to lower leverage. E.g. relinquish a property for $5,000,000 which bears a $500,000 mortgage.  If the investor wants to own the next NNN property free and clear, complete a partial 1031 exchange by purchasing a replacement property for $5,000,000 in cash and paying taxes on the $500,000 boot.

WHEN NOT TO DO ENGAGE IN A PARTIAL 1031 EXCHANGE

Generally, if the taxable boot is greater than the amount of the capital gain, it may not be worthwhile to engage in a partial 1031 exchange. Every investor should review their specific 1031 exchange situation with a tax and legal advisors before closing on the sale of the relinquished property for a partial 1031 exchange.

For outstanding advisory regarding full or partial 1031 Exchange NNN properties, please call or email your trusted “deal team” at The Triple Net Investment Group.