Partial 1031 Exchanges and Reverse 1031 Exchanges

Selling an investment property can be a lucrative move, but it often comes with a hefty tax bill. A 1031 exchange is a powerful tool that allows investors to defer capital gains taxes by reinvesting proceeds into a like-kind property.

However, what if you want to keep some cash for liquidity or secure a new property before selling your old one?

That’s where partial 1031 exchanges and reverse 1031 exchanges come into play.

While most investors are familiar with traditional exchanges, these two strategies offer unique benefits and flexibility. This article breaks down how each works, their advantages and drawbacks, and which option might be right for you.

What Is a Partial 1031 Exchange?

A partial 1031 exchange, also known as a split exchange, allows an investor to defer taxes on a portion of the proceeds while keeping some cash. Unlike a full exchange, where all proceeds must be reinvested to defer capital gains entirely, a partial exchange gives the investor access to some funds while still benefiting from tax deferral.

How Does a Partial Exchange Work?

The process follows the same IRS rules as a standard 1031 exchange, with strict 45-day identification and 180-day closing deadlines.

The key difference is that the investor does not reinvest all of the sale proceeds into a replacement property. Any amount not reinvested is called “boot”, which is subject to capital gains tax.

Types of Boot in a Partial Exchange

Boot refers to any taxable portion of the exchange. It can take different forms:

• Cash Boot: Any cash proceeds taken out of the exchange.
• Mortgage Boot: A decrease in debt between the relinquished and replacement properties. If the investor does not take on equal or greater debt in the new property, the difference is taxable.

Example of a Partial 1031 Exchange

Let’s say you sell an investment property for $1 million and identify a replacement property worth $800,000.

The remaining $200,000 is considered boot and is subject to capital gains tax. If your long-term capital gains rate is 15%, you would owe $30,000 in taxes on that boot.

Pros & Cons of a Partial 1031 Exchange

Pros:

• Access to cash for personal use or reinvestment.
• Maintains some tax deferral benefits.
• Reduces leverage on the replacement property.

Cons:

• Boot is taxable, potentially reducing overall tax savings.
• If boot is too high, the exchange may not be worthwhile.
• Requires careful planning to avoid unexpected tax liabilities.

What Is a Reverse 1031 Exchange?

A reverse 1031 exchange allows an investor to purchase a replacement property before selling the relinquished property. This strategy is useful when an investor finds a great opportunity but has not yet sold their current property.

How Does a Reverse Exchange Work?

Since IRS rules prohibit an investor from owning both the relinquished and replacement properties simultaneously during an exchange, a Qualified Intermediary (QI) or Exchange Accommodation Titleholder (EAT) must hold the title to one of the properties until the transaction is completed.

Key Steps in a Reverse 1031 Exchange

1. Secure Financing & Identify an Exchange Accommodator Titleholder (EAT) – The EAT temporarily holds the title to the new property.
2. Purchase the Replacement Property – The investor buys the new property before selling their current asset.
3. Identify the Relinquished Property (Within 45 Days) – The investor must declare which property they intend to sell.
4. Sell the Relinquished Property (Within 180 Days) – The old property must be sold within six months to complete the exchange and maintain tax deferral.
5. Complete the Exchange – The proceeds from the sale of the old property are used to pay off the EAT, officially transferring ownership of the new asset to the investor.

Example of a Reverse 1031 Exchange

An investor finds a $1.5 million commercial property that is a perfect fit for their portfolio but has not yet sold their $1.5 million multifamily building. The investor works with an EAT to acquire the new property first. Within 180 days, they sell their multifamily building and use the proceeds to finalize the exchange, successfully deferring capital gains tax.

Pros & Cons of a Reverse 1031 Exchange

Pros:

• Ensures you secure the ideal replacement property without time pressure.
• Avoids issues with tight real estate inventory.
• Provides flexibility in timing the sale of the relinquished property.

Cons:

• Requires more upfront capital or financing.
• More complex and costly than a standard 1031 exchange.
• If the relinquished property doesn’t sell within 180 days, the exchange fails, triggering tax liabilities.

Key Differences: Partial vs. Reverse 1031 Exchanges