You can do a partial 1031 into a lesser valued replacement property, but if you want to defer 100% of the gain, you typically need to continue your investment into an equivalent or more valuable replacement properties (see the napkin test).
3 General Rules
There are three general rules of thumb to quickly see if you will defer all of the recognition of gain in your 1031 exchange:
- Typically you will acquire replacement property that is “up or equal” in value (price).
- You will roll over all of your equity (net proceeds) from the relinquished property into your replacement property.
- And to the extent that you were relieved of liabilities and debt, such as mortgages on your old relinquished property, the debt relief is offset by:
- new liabilities or mortgages taken on in conjunction with your purchase of the replacement property; OR
- by investing additional cash in the replacement property equal to the amount of liabilities and debts that were discharged.
Partial Victory Is Better Than None At All
If you have a low basis, you may be satisfied to defer part of your gains and to pay your taxes on the difference, this is often called a partial 1031 exchange. Generally this occurs when a taxpayer wants to buy only a replacement property of lesser value, or prefers not to re-invest all of their equity (1031 funds) from the disposition of their old relinquished property into their new replacement property.
1031 Post-Exchange Refinance Alternative
If you are considering holding back some money from your exchange (taxable boot) and only re-investing a portion of your equity (1031 funds), then be sure to call me first, as we may be able to discuss some other ways to get you the same amount of cash without triggering the recognition of gain during your 1031 exchange.
Tax Treatment of Loans
One option to consider is to complete your exchange by re-investing ALL of your equity (1031 funds) into a replacement property of equal or greater value; and then later in a subsequent (separate post-exchange) transaction, pull out some equity by refinancing your replacement property to access some of the equity. Generally, borrowing money is not considered income because you have a corresponding obligation to repay the loan. When tax rates are high and interest rates are low, it doesn’t take a rocket scientist to figure out that by delaying your gratification until later after your exchange is over you can save a significant amount in taxes.
- 1031 Hotline: If you have questions about 'partial 1031 exchanges' or how to refinance after the exchange to get your money out tax-free, feel free to call me at 612-643-1031.
Defer the tax. Maximize your gain.
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