A Mixed Bag Transaction – Partial Tax Deferred Exchanges

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Back in the day I used to teach after tax cash flow analysis to house agents wanting to venture over to what they often referred to as the Dark Side. It was spread over a few classes, one of which was the bottom line effect of tax deferred exchanges. Usually there was an investor or two in the class. Without exception they were more than mildly surprised, sometimes chagrined to learn 1031 exchanges weren’t analogous to being pregnant. What? Huh? They thought you either executed an exchange or you didn’t, in the same sense you can’t be partially pregnant. You either are, or you’re not.

Partial tax deferred exchanges are not only common, but often far more advantageous for the investor. The next obvious question of course, is why? Here are three reasons a real estate investor might wanna do only a partial 1031, plus an example of a partial tax deferred exchange (1031) from my files.

Reason: You may wish to withdraw some cash from the exchange proceeds — paying the capital gains tax. This is known as taking ‘boot’.

Reason: You may want cash, not now, but in the near future, yet still want/need to exchange some/most of the property’s equity, tax deferred. You’re willing to pay the capital gains tax on the future ‘recognized gain’ (cash received).

Reason: You have the ability to offset a portion of the gain you’re deferring through the exchange. Maybe a capital loss, or unused depreciation sittin’ on the shelf.

Here’s a partial tax deferred exchange we executed for a client. It was one of the fun ones.

First, let’s take a look at what the client needed to happen — along with the facts of his situation at the time.

The Facts

  • He was nearing retirement from his $185,000/yr job, having planned it for the early summer of 2004. It was October of 2001 when we began to set the wheels in motion for this transaction.
  • His net equity was roughly $300,000.
  • He wanted an immediate $50,000 in cash from the proceeds — tax free if possible.
  • Though retiring in 2004, an EIUL wouldn’t begin to pay out ’till 2006. He wanted a few years of supplemental income to augment his real estate cash flow ’till then.

Here’s how I structured the transaction

1. Split 30% down payment — 20% at closing, with the remainder in the new tax year just 30 days later.

2. Owner financing — this killed three birds. First, it allowed for the second installment of the down payment through a principal pay down in the note. Second, it reduced the taxes on that second payment because of it’s timing — the new tax year mentioned earlier. Third, it provided the supplemental income he wanted while waiting for his tax free EIUL income to commence.

3. Really a bonus derived from #2. The note was due and payable in the summer of 2006 — a year when his taxable income would be very low, relatively speaking.

The timing was exquisite, as it was the end of the calendar tax year, and perfect for splitting up any gains into two tax years. We did this by employing a split down payment. The 30% down payment was split into an initial 20% at closing, followed a month later (A new calendar tax year.) by the remaining 10%. The latter was in the form of a principal pay down in the financing my client carried back.

The net proceeds from the down payment/new senior loan was dutifully exchanged, tax deferred.

When the note balance was paid off in 2006 (and right on time), my client, then 64, added $15,000 of it to his cash reserves, which had already been impressive, and immediately bought a separate EIUL which he planned to let simmer at least a decade for even more tax free income.

To summarize — his tax returns in the following years showed the following.

  • His 2001 return showed a portion of his proceeds were exchanged for more property, all of which was tax deferred.
  • It also showed a $115,000 note given as part of  the purchase price, which was treated as a partial installment sale. He pays taxes on the interest in the year received. The payments were interest only.
  • His 2002 return showed the receipt of a $45,000 principal pay down on the note. Some of this was treated as return of capital and not treated as gain. The remainder was treated as gain, and subject to capital gains tax. However, he offset that gain with unused depreciation, eliminating any tax owed. This met his need, (almost) for the $50,000 he wanted immediately. It was $5,000 short, and 30 days later than ‘immediate’, but he was content.
  • His 2006 return showed his note paid in full. He was able to offset just under half of the capital gain portion (return on capital) by using the rest of his unused depreciation. His tax bill was much lower than it could’ve been.

None of this happened by itself, as it was part of a pretty detailed Plan. What it illustrates clearly, is what’s possible when you learn the answers to questions you never knew to ask.

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

2 Comments

  1. This sounds great but there are a ton of details in there. I’m a new real estate investor and don’t know that I’ve read about something so complex. Is this kind of transaction something that I can learn about from my local agent, or is there a good book that spells this stuff out?

    Also, Why did you split the down payment in your first point?

  2. Jeff Brown

    Ed — Complexity is in the eye of the beholder, though I surely won’t disagree with you. A book? I’ve had the policy not to recommend books on the subject, because I’ve had bad experiences with folks reading ‘chapter 3′ and tryin’ it out. 🙂 That said, it took me roughly 400 hours in narrowly defined, intense training to reach rookie, wet-behind-the-ear status. If you’re seriously interested in learning it cold, I recommend the CCIM program. Also, seminars conducted by folks who’re actually in the front lines, or were for many years, helped me immensely. All that high quality training would’ve still fallen short if I hadn’t had some of the best, most generous, gracious mentors anyone could hope for.

    The down payment was split just in case the info given me by his CPA was faulty as it related to the amount of unused depreciation available to offset any gain he chose to ‘recognize’. Over the years I’ve learned CPAs are sometimes not as up to snuff on the sections in the IRC dealing with real estate as their clients think. It shifted the tax, if it was indeed incurred, to the following tax year. Since it was only a 30 day wait, it made sense as a backup plan. In other cases I’ve spread principal pay downs on seller ‘carry backs’ over multiple years for the same reason. It’s also a nice planning device when the taxpayer/investor has foreknowledge of a low income year in the future. There have been a few times I’ve seen clients actually slide down a tax bracket using this strategy.

    The chances your local agent understands this at even a rudimentary level are slim, fat, and none. My experience with the locals here in San Diego who sell 1-4 units to investors is that they know just enough to get a purchase escrow closed, but go into stutter mode down the line when the client asks the question, “Now what?”

    Make sense?
    .-= Jeff Brown´s last blog ..Munchin’ On The Numbers =-.

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