1031 Exchange: Full vs. Partial Tax Deferral

by Maura Snabes, Esq., CES, NTP

1031 Exchange: Full vs. Partial Tax Deferral

One common misconception about a Section 1031 Exchange is that it must be an “all or nothing” transaction in order to qualify. That is not the case. A taxpayer can still complete a valid 1031 exchange while partially deferring gain, if they trade down in value or receive some cash back (“boot”).

It’s important to remember: a 1031 exchange provides tax deferral, not tax forgiveness.

To Fully Defer Taxes in a 1031 Exchange, the Exchanger Must:

• Purchase replacement property of equal or greater value

• Reinvest all equity into the replacement property

• Replace the debt paid off on the relinquished property (or offset it with additional cash)

• Avoid receiving cash or other benefits from the exchange proceeds (“boot”)

What Is “Boot”?

Any cash or non-like-kind property received during the exchange, or received back from the Qualified Intermediary upon termination/conclusion of the exchange, is considered “boot” and may be taxable.

Examples of boot can include:

• Cash proceeds

• Debt reduction (mortgage boot)

• Seller financing or notes

• Furniture, equipment, or other personal property

Example 1 – Trade Down in Value

Relinquished Property

• Sale Price: $1,000,000

• Mortgage: $300,000

• Equity: $700,000

• Original Basis: $500,000

• Potential Gain Without Exchange: $500,000

Replacement Property

• Purchase Price: $800,000

• Mortgage: $300,000

Result:

• $200,000 reduction in value/equity

• Potential taxable boot: $200,000

Example 2 – Trade Down in Value and Debt

Relinquished Property

• Value: $1,000,000

• Debt: $300,000

Replacement Property

• Value: $800,000

• Debt: $200,000

Result:

• $200,000 reduction in value

• $100,000 reduction in debt

• Taxed on greater of the trade down in value or equity to the extent of the realized gain = $200,000.

Example 3 – Same Value, Less Debt

Relinquished Property

• Value: $1,000,000

• Debt: $300,000

Replacement Property

• Value: $1,000,000

• Debt: $200,000

Result:

• $100,000 mortgage boot

• Taxable unless the taxpayer contributes an additional $100,000 cash into the replacement purchase. Cash paid by taxpayer at replacement property closing can offset mortgage boot received.

Bottom Line

A Section 1031 Exchange does not have to be “all or nothing.” Taxpayers can partially defer gain, pay taxes only on the boot received, and still receive substantial tax-deferral benefits.

As always, taxpayers should consult with their CPA or tax advisor regarding gain calculations, tax implications, property qualification, and whether a 1031 exchange is appropriate for their situation.