Navigating Tax Opportunities in 1031 Exchanges | Part III

Advanced 1031 Topics Including Exchange Considerations for Partnerships

This session delves deeper into advanced 1031 exchange topics including carryover basis, boot, and deferred vs. recognized gain calculations, depreciation matters, cost segregation relevance, and methods for existing partners in partnerships to not continue in 1031 exchanges.

We’re covering advanced topics related to 1031 exchanges including boot, depreciation strategies, recovery periods, and allocating excess basis. These topics are especially important to understand as bonus depreciation starts to wind down.

Understanding boot in 1031 exchanges

The goal of a 1031 exchange is to achieve a non-recognition transaction where no gain is recognized on the sale of old property.

Non-recognition treatment applies when one exchanges old property exclusively for like-kind new property or replacement property. However, it’s considered a boot if one does not get a new like-kind property or if a cash benefit comes from the deal.

Aside from a cash gain, relief of liabilities is also considered a boot. If you sell property and there is debt on the property, the relief of that debt is a boot, which can be mitigated if you acquire new property with either one, the same amount of debt, or two, with cash. A key takeaway is that proceeds from the sale of a relinquished property can be used to pay off the debt on the old property if you then incur debt on the purchase of the new property that equals or exceeds the debt on the old property.

In the current economic environment, if you are selling a property and then you want to buy a replacement property with the same fair value but assume that banks don't want to underwrite that loan to value, an alternative is that you could infuse more cash into the exchange to acquire the replacement property. The recognized mortgage boot or the decline in a mortgage can be offset by the cash you put in. On the other hand, this situation is not reciprocal as one cannot offset cash boot with additional debt.

A boot is dollar-for-dollar gain recognition. For example, if there is $200 of sales proceeds and $50 of adjusted tax basis, the recognized gain is $150. Let us assume we have $25 for the boot. Your recognized gain is not pro rata, as you don't get to absorb the basis against that gain. The boot carries with it an income equal to the boot. A boot does not necessarily cause a 1031 exchange to fail. At a certain point, if an organization or person has too much boot, a 1031 may not make sense if most of the gains are not recognized.

Receiving a boot is not always bad, depending on your situation. Getting a boot makes cash available for personal use or future investments. However, it does make the property subject to tax.

Depreciation strategies in 1031 exchanges

Smart depreciation strategies can enhance your investments to minimize potential tax burdens caused by boots. When a property is relinquished, depreciation continues until the day of sale.

There is no depreciation in intermediate period between the sale of that property and the purchase of the replacement property. Often, a property will be sold before the year-end, and your replacement property won't be bought until the following tax year. This allows you to have a period of no depreciation, which can be beneficial.

What is the recovery period?

Many questions can arise when strategizing a deprecation plan, especially concerning recovery periods. In the recovery period of a replacement property, the new property is the same or shorter than the original property, and one follows the same recovery period as your relinquished property. Unfortunately, if you are buying a property with a longer recovery period, you must use the longer period on the new property.

If you are selling residential property that is 27 and a half years old and you are purchasing commercial property that has a 39-recovery period, you now must depreciate that carryover basis as if you were always on a 39 period. So, effectively, you're prolonging the depreciation recovery timeline on that carryover basis.

How do we allocate excess basis?

Additional cash or new debt generates what regulators consider an excess basis. The excess basis is treated as placed in service in the year of replacement. So, it's treated as a new property acquired in the year you buy the replacement property, and you effectively must look at all the applicable depreciation attributes of that new property. This may include bonus depreciation and is where cost segmentation provides value. That may produce a bonus depreciation if you can allocate some of the added basis to lower-class lives.

It is important to note that one cannot select how to distribute an excess basis. One must look at the true amount of the excess basis rate that can be allocable to potentially a cost seg, which is eligible for bonus depreciation. Bonus depreciation over the last several years was 100% but went down to 80% in 2023 and 60% in 2024. As bonus depreciation will continue to phase out over the next several years, consulting with a cost segregation team is worthwhile if you are trading up in fair value on a 1031 exchange.

More Insights On-Demand

For more detailed information on navigating 1031 exchanges, watch our full on-demand webinar above.

Our speakers dive deep into advanced 1031 exchange topics including carryover basis, boot, and deferred vs. recognized gain calculations, depreciation matters, cost segregation relevance, and methods for existing partners in partnerships to not continue in 1031 exchanges.