“Pro et Contra” From Latin “Pro et Contra” typically translates to “Pros” and “Cons”. Basically meaning arguments for, or against a particular issue. When entering or exiting a partial 1031 tax deferred exchange (either by design or accident) there are pros and cons.
By Al DiNicola, AIF®, CEPA ™
July 7, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
There may be three reasons why a partial exchange occurred. The reasons may be by design; one or more of your identified properties became unavailable for some reason, or; the final negotiated price on your replacement properties did not use all the cash.
Intentional or Unintentional
If entering a partial exchange by design, the real estate investor may be seeking to access cash tied up in the real estate for a variety of purposes. The funds may be used to take a vacation, business funding, pay for a child’s college or wedding or other reasons. When you sell your property via a 1031 tax deferred exchange it is possible (by design) to retain a portion of the funds. The other two reasons, where you receive cash, may have occurred unintentionally.
There are a variety of reasons why all the cash may not be used in a 1031 exchange. If only a portion of the cash is used in the exchange, then that portion would enjoy the tax deferral. Retaining a portion of the proceeds is considered a partial exchange. Partial exchanges happen every day. The proceeds not invested in a 1031 exchange is considered “boot” and subject to capital gain taxes. There is also another type of tax that would be due and that would be the recapture of depreciation taken on the property. There may also be another type of boot called mortgage boot. That is another topic for discussion.
Partial Exchange Review
The IRS has very strict rules, guidelines, timing as well as other regulations regarding successfully executing a 1031 tax deferred exchange. The planned partial exchange happens when an investor knows specifically, they want to retain proceeds from the exchange after the replacement property is acquired. Other partial exchanges may occur when investors may have identified multiple properties on their list and find out after the 45-day period has expired that one of the properties they intended to purchase is no longer available. Yet another partial exchange may occur when investors negotiate a price on the replacement property (lower than the required market replacement value) and have proceeds left over.
First things first.
We cannot emphasize enough the importance of the Qualified Intermediary (QI) holding the proceeds of sale of your relinquished property. After an investor closes on the relinquished property and enters the 45-day identification period, there are a lot of unknowns as to the actual cost of the replacement property. Once the final negotiated price has been established and all closing cost have been estimated the investor should have a good idea on the excess proceeds that may be available. The investor may have designed for cash to be left over. If the cash left over is not by design, then a Delaware Statutory Trust (DST) may provide a solution.
Receiving your Funds
So when can you receive the excess funds from the QI? Actually, it depends. It depends on a few items that may or may not have been included on your 45-day list. We will elaborate but in either case as soon as you receive the proceeds, you are liable for paying taxes on the process you receive.
Why does it depend on how you filled out the 45-day form? If you have only placed one property on the form and successfully closed on the one property, then on the 46th day the QI will return your excess proceeds. However, if you have placed 2or 3 properties on the form and only closed on one property, then the QI is required to hold your funds for the 180 days and return on the 181st day.
Stepping back to understand
Here is an example of how the partial exchange may work. You just sold a property for $700,000 and there was no mortgage on the property. The new property costs $500,000. If you only close on the one property, and retain $200,000, you will be taxed at your ordinary tax rate. The $200,000 that is not reinvested into the replacement property is called boot. Under the 1031 regulations the replacement property must be equal to or greater than the relinquished property.
Are there positives to a Partial 1031 Exchange?
One positive of the partial exchange is the ability to access your cash that was tied up in the real estate. Access to cash may be needed for an emergency and once cash is received the investor may use the cash for any reason. Again, the cash is subject to tax. DSTs have provided a viable solution for left over cash or as a back up to replacement properties that cannot be acquired.
DSTs also offer a potential solution when failing to replace leverage and debt. A question often arises from investors who sell a property that has debt but wants to eliminate future recourse debt. Here is an example. The investor is selling a property for $700,000 and has a remaining loan on the property in the amount of $100,000. The investor locates a property for $600,000. The investor is avoiding applying for and being responsible for debt in the amount to $100,000. The $100,000 loan that was paid off (and not replaced) would be considered mortgage boot and subjected to being taxed. By structure many DST come prepackaged with non-recourse debt. Each DST will have their own loan to value (LTV) and there are additional DST alternatives that may provide a solution to provide a tax free (deferred tax) complete exchange. DSTs have been a viable alternative for boot.
“Contra” The Drawbacks utilizing a Partial 1031 Exchange
The biggest drawback would be the requirement to pay taxes on the cash boot or the mortgage boot.
Executing a partial exchange is an acceptable alternative to a typical 1031 tax deferred exchange. Understanding your individual situation is most important. If an investor needs access to cash tied up in the real estate for other financial needs this may be the prudent course of action. We have assisted investors explore the partial exchange as well as execute the partial exchange. We have assisted investors who have sold a property they have owned for thirty years. Over the time of ownership, the entire mortgage has been paid off and now they have no debt. In addition, the property represented close to 100% of their assets besides their primary residence. The investor has grown tired of dealing with the tenants (toilets & trash) as well as active management. The DST may provide a great solution for a passive investment. There are a few words of caution. DSTs are considered an ill-liquid investment and do not provide an opportunity to tap into for accessing cash. You may also not be able to utilize a DST as collateral to borrow against. The partial exchange may provide you with access to cash albeit you will pay tax on the cash not reinvested but retained.
Please consult your CPA or tax advisor to discuss your individual solution. .
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email firstname.lastname@example.org.
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