A partial exchange, whether planned or by happenstance, can be a viable exchange strategy. The words “can be” imply that there are circumstances when this would not yield a positive outcome. A partial exchange will result in some taxable gain being triggered; however, it could also mean having to pay all the tax- Ouch! Understanding the difference between paying some tax and paying all of the tax is very important.
There are several different pieces of information and several calculations that must be used to determine whether you will have a positive or negative result. Let’s explore how this works with an example:
Tina bought a rental property ten years ago for $300,000. She is now selling the property for $640,000. There are $40,000 of selling expenses resulting in a $600,000 Net Sales Price and there is a $200,000 balance left on the loan.
At the closing, the $640,000 proceeds will first be used to pay the $40,000 of selling expenses resulting in a $600,000 Net Sales Price. Then the proceeds will be used to pay off the $200,000 loan balance. This will leave $400,000 of net proceeds due Tina. She originally paid $300,000 for the property, so she achieved $300,000 of appreciation. Over her ten-year ownership, she reported a total of $100,000 of depreciation. Her total gain can be calculated by adding together the $300,000 of appreciation + the $100,000 of depreciation(depreciation recapture) = $400,000.00. Her adjusted tax basis is calculated by subtracting the total gain (appreciation + depreciation) from the Net Sales Price, $600,000 – $400,000 = $200,000 Adjusted Basis. To determine the actual amount of tax, the $400,000 total gain would be multiplied by her applicable tax bracket percentage.
Tina wants to defer some, if not all, of the $400,000 of gain via a 1031 exchange. For her to better understand how this would work, she will focus on three key items above: the Adjusted Basis of $200,000, the Net Sales Price of $600,000 and the $400,000.00 Net Proceeds. When doing a 1031 exchange the Net Sales Price is referred to as the Minimum Target Value.
Tina contacted us to help her with a 1031 exchange. We explained that to defer all of the gain in a 1031 exchange, she must buy replacement property that costs the same or more than the Net Sales Price of the relinquished property AND all of the cash must be used. Otherwise, the remaining cash will be taxable. Additionally, if the replacement cost is below the Minimum Target Value then additional tax will be due if it is greater than the amount of cash kept.
If Tina buys replacement property for $500,000 using all of the $400,000 proceeds in her exchange account and secures a $100,000 loan, she will have missed her minimum target value by $100,000. The result? She will pay taxes on $100,000 of gain (this is called mortgage boot – See: Debt Replacement and defer tax on the $300,000 gain balance. What is the result if Tina buys a replacement property for $800,000, puts down $200,000 and gets a loan for $600,000? She has no problems with the minimum target value because she exceeded it by $200,000 but there will be $200,000 of proceeds left. Therefore, she will pay taxes on $200,000 of gain and defer tax on $200,000 of gain.
What happens if Tina buys replacement property for $200,000? She will have missed the minimum target value by $400,000, which is the total amount of her gain. This will result in paying all of the tax.
Let’s revisit the $800,000 replacement property option. What if Tina buys the $800,000 property using all of the $400,000 net proceeds? No tax will be triggered because she will have used all of the cash and bought property that was the same price or greater than the $600,000 Net Sale Price of the relinquished property.
Yes, this article is about partial exchanges, but to understand the amount of tax savings you will achieve is dependent on the aforementioned points.
After reviewing her options Tina decided to keep $100,000 from the sale and knows she will pay tax on this amount of cash. For this to be best accomplished, she needs to buy replacement property that costs $500,000 or more and use $300,000 cash in the purchase. Why $500,000? Wasn’t the Minimum Target Value $600,0000? This is because you get to net the cash you keep against the minimum target value. The $100,000 she kept reduced her Minimum Target Value from $600,000 to $500,000.
In this transaction, Tina did accomplish partial tax savings because she bought replacement property that costs more than the $200,000 Adjusted Basis. The amount of partial deferral will depend on the combination of the replacement property cost that is above $200,000, and how much cash she decides to keep.
I hope you find this information helpful. Remember that deferring tax in a 1031 exchange is not an all-or-nothing proposition and yes, the tax rules are complicated but I hope this article will help better equip you to make more informed decisions. As always, if you have questions, you are welcome to call. We will be glad to assist.
(The above explanation and example assume there were no capital improvements made to the relinquished property, that the property being sold was not acquired as part of a 1031 and that there was no land value.)
