Understanding Tax Implications When a 1031 Exchange Doesn't Go as Planned
A 1031 exchange is a powerful tool for deferring capital gains taxes on the sale of investment real property. But what happens if the like-kind exchange doesn’t fully succeed? Maybe you could not identify a replacement property in time, or you chose not to reinvest the entire sale proceeds. Does that mean you are automatically hit with a huge tax bill?
Not necessarily, but partial exchanges do trigger tax consequences that should be understood ahead of time.
Understanding Boot and Partial 1031 Exchanges
When a taxpayer conducting a 1031 exchange receives cash or non-like-kind property as part of an exchange, that portion is known as "boot" and it is taxable to the extent of the realized gain.
It’s a common misconception that you can receive your “original basis back” tax-free. In actuality, the IRS taxes gain before basis is recovered when boot is received. So, if your relinquished property sells for $500,000 and you have $300,000 of basis, any boot received is first applied against your gain, not your basis. “Boot” triggers recognition of gain, and that gain is taxed before any remaining basis is returned to the taxpayer. Why does this happen? In a 1031 exchange, your old basis transfers to the replacement property. The IRS does not allow you to recover basis tax-free ahead of recognizing gain when boot is involved.
What Taxes Might Apply?
When a 1031 exchange is only partially completed, or if it involves boot, here are the types of taxes you may be subject to:
§1245 Recapture: Up to 39.6%
Applies to depreciation on personal property or components of certain mixed-use assets.§1250 Depreciation Recapture: Up to 25%
Depreciation taken on real property is subject to recapture if gain is recognized by the taxpayer.Federal Capital Gains Tax: Up to 20%
Applies to any appreciation not offset by basis or depreciation.§1411 Net Investment Income Tax: 3.8%
This surtax applies to high-income taxpayers over a certain threshold with passive real estate income or gain.State and Local Taxes: Varies
Several states and many municipalities impose their own capital gains or income taxes on real estate transactions.
Planning Is Key
Partial exchanges occur for many reasons: tight market conditions, failed inspections, financing limitations, or timing challenges. But with proper planning, the tax impact of receiving boot can be anticipated, calculated, and in some cases, mitigated.
For example:
You may choose to receive boot in the form of a mortgage payoff or cash back at closing with full awareness of the tax it triggers.
Alternatively, you might decide to complete a full exchange, then consider a refinance after closing in a separate transaction to access liquidity in a more tax-efficient manner.
Partial 1031 Exchanges Still Offer Beneficial Tax Deferral
A “less than perfect” 1031 exchange doesn’t eliminate all the benefits of tax deferral. Even partial deferral can improve your financial position, but you must understand how the IRS applies gain recognition when boot is involved. Remember: gain is taxed before basis is returned.
If you are considering a 1031 exchange and wondering about partial reinvestment, depreciation recapture, or the impact of boot, now is the time to consult a qualified tax advisor.
Thinking about a 1031 exchange? Feel free to call me, Jeff Peterson, at 612-643-1031, or email me at jeffp@CPEC1031.com.
Defer the tax. Maximize your gain.
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