Can You Take Cash Out of Your 1031 Exchange?
A 1031 Exchange is a real estate investment strategy used to avoid capital gain taxes. Many investors choose a 1031 exchange to avoid paying thousands of dollars on gains at the time of the sale of their property. This allows them to transfer the tax liability of their relinquished property to the new like-kind replacement property or properties, and save a ton of money in the process.
The rules and regulations of a 1031 exchange clearly state that you cannot execute an exchange to make a profit on your sale. Because of this reason many real estate investors often complain that they are real estate rich and cash poor. A partial 1031 can help solve that problem. Let’s take a look at how a partial 1031 exchange may work for you.
Everything you need to know about a partial 1031 exchange
A 1031 exchange can be the best solution to defer your capital gain taxes. But sometimes paying a little bit of tax is worth the cost, especially compared to the benefit of having some extra cash on hand for personal uses or investments other than real estate, or when you can’t find a good replacement property that’s worth more than the property being relinquished.
Cash taken out of a 1031 exchange is commonly termed “boot”, and if you choose to do a partial 1031 exchange then you have to pay taxes for the received boot only. Capital gains tax rates currently are 0%, 15%, and 20% depending on your income level and tax filing status. Usually, if you plan ahead, you can retain parts of the sales proceeds from the relinquished properties while the remaining funds used in the 1031 exchange can be reinvested with taxes completely deferred.
Even if you take out the boot, a partial 1031 exchange process remains almost identical to a regular exchange. This means, you still have to follow the 45-day identification period and the 180-days widow to close the sales. The 200% Identification Rule and the 3 Property Rule can also be used in a partial 1031 exchange.
What to keep in mind while taking cash out of a 1031 exchange
As a real estate investor, you may intentionally conduct a partial 1031 exchange by instructing your QI (Qualified Intermediary) to disburse a specific amount of the funds from the sale of the relinquished property. However, if you’re not careful, a partial 1031 exchange can also occur when taxable boot is accidentally created.
There are other creative ways that make it possible to have your cake and eat it too. With a little bit of advanced planning, you can conduct a normal delayed 1031 exchange that defers all of your capital gains tax and still gets some money back in your pockets.
Here are two alternative ways to get some money back and still defer your capital gains tax liability:
1. Cash-out refinancing
Doing a cash-out refinance as a separate transaction before or after you complete your 1031 Exchange is one way to pull some cash out to have on hand.
2. Use existing carryforward losses
If you have outstanding losses from other transactions that you’ve been carrying forward or deductions that you haven’t yet completely expensed, you may be able to use those to offset any capital gains tax liability generated by the boot in a partial 1031 exchange.
As always, we recommend meeting with your tax advisor before making any decisions, then contacting us when you are ready to pull the trigger on your 1031 Exchange!