Can You Do a Partial 1031 Exchange? Here’s What to Know

A 1031 exchange allows real estate investors to defer capital gains taxes when selling a property and reinvesting in another of equal or greater value. Many wonder if they can do a partial exchange—where only part of the proceeds are reinvested while keeping some cash from the sale.

This approach is possible but comes with tax implications. Understanding how a partial 1031 exchange works helps investors make informed decisions.

Core Requirements

For a 1031 exchange to qualify for tax deferral, the replacement property must be “like-kind” to the relinquished property, meaning both must be held for investment or business purposes. This definition is broad, allowing exchanges between different types of real estate, such as swapping a rental apartment for a commercial building. Personal-use properties, such as primary residences, do not qualify.

The exchange must be handled by a qualified intermediary (QI), an independent third party who holds the sale proceeds in escrow and facilitates the transaction. The seller cannot take direct possession of the funds, as doing so triggers immediate tax liability. Any misstep in handling the funds can disqualify the exchange.

Timing is crucial. The investor has 45 days from the sale of the original property to identify potential replacement properties in writing. The IRS allows three identification methods:

– Three-Property Rule – Up to three properties can be listed, regardless of value.
– 200% Rule – Any number of properties can be listed, as long as their combined value does not exceed 200% of the relinquished property’s sale price.
– 95% Rule – The investor must acquire at least 95% of the total identified properties’ value.

The replacement property must be acquired within 180 days of the original sale.

Boot and Partial Investment

A partial 1031 exchange occurs when an investor reinvests only part of the proceeds while keeping some cash or receiving non-like-kind property. The portion not reinvested is known as “boot” and is subject to capital gains tax.

Boot can take different forms:

– Cash Boot – If a property sells for $500,000 and only $400,000 is reinvested, the remaining $100,000 is considered cash boot and taxed as a capital gain. The tax rate depends on the investor’s holding period and tax bracket, with long-term capital gains typically taxed at 15% or 20% federally, plus any applicable state taxes.
– Non-Cash Boot – If an investor receives non-like-kind property, such as furniture or equipment included in the deal, the fair market value of those items is considered boot and taxed accordingly.

Debt Replacement Rules

When structuring a partial 1031 exchange, investors must consider how debt on the relinquished property affects tax deferral. The IRS requires that the total value of the replacement property, including assumed liabilities, be equal to or greater than the relinquished property to fully defer capital gains taxes. If the investor does not replace the full amount of debt, the difference is considered mortgage boot and is taxable.

For example, if an investor sells a property with a $300,000 mortgage and acquires a replacement with only $250,000 in financing, the $50,000 shortfall is treated as boot. This applies even if the investor does not receive cash directly, as the IRS views debt relief as a form of economic benefit. To avoid this, investors can either take on an equivalent or greater loan amount for the new property or contribute additional cash to offset any reduction in debt.

Some investors manage debt replacement by structuring financing to meet IRS requirements while maintaining flexibility. Seller financing arrangements, where the seller of the replacement property provides a loan, can help bridge any potential gap. Others may use cash reserves to ensure the total investment matches or exceeds the relinquished property’s value.

Effects on Taxable Gain

The taxable gain in a partial 1031 exchange depends on how the transaction is structured. While the reinvested portion remains tax-deferred, any amount retained or used for non-qualifying purposes is immediately taxable. This includes cash withdrawals and costs deducted from the proceeds that are not part of the replacement property’s value, such as prorated rent, security deposit transfers, or loan fees.

Depreciation recapture can further impact taxable gain. If the relinquished property was depreciated, the IRS requires that a portion of the previously claimed deductions be recaptured at a maximum rate of 25%. This applies even if most of the proceeds are reinvested, meaning an investor may still owe taxes on prior depreciation benefits. The recapture amount is the lesser of the total depreciation taken or the recognized gain from the partial exchange.

Required Documentation

Executing a partial 1031 exchange requires detailed documentation to ensure compliance with IRS regulations. The IRS scrutinizes these exchanges closely, making a well-documented paper trail essential.

Key documents include:

– Exchange Agreement – Outlines the terms between the investor and the qualified intermediary (QI), specifying that the intermediary will hold the proceeds and facilitate the acquisition of the replacement property.
– Assignment of Contract – Transfers the investor’s rights in the sale and purchase agreements to the QI, ensuring the investor does not take constructive receipt of funds.
– Form 8824 – Filed with the IRS, this form provides a breakdown of the transaction, including property descriptions, timelines, and any taxable boot received.
– Closing Statements (HUD-1 or ALTA settlement statements) – These documents detail the financial aspects of the exchange, including loan payoffs, prorations, and any cash received.

Timeline for Exchange Steps

Successfully completing a partial 1031 exchange requires strict adherence to IRS deadlines. Any deviation can disqualify the transaction, leading to immediate tax liability.

The process begins with the sale of the relinquished property, at which point the 45-day identification period starts. During this window, the investor must formally identify potential replacement properties in writing to the QI. The identification must follow one of the three IRS-approved methods. Once identified, the investor has a total of 180 days from the sale date to complete the purchase. These deadlines run concurrently, meaning if an investor waits until the 45th day to identify properties, they will have only 135 days remaining to close on the acquisition.