1031 Exchange Rules: What Investors Fear?

Rules For 1031 Exchange Properties

I’m looking to sell an investment property and purchase a new one. Surely, I want to defer capital gains tax using a 1031 exchange. However, I also want to save a bit of cash from the sale of the relinquished property. I wonder if I could do both?

In general, Investors fear that they can’t keep any of the proceeds from the sale of their relinquished property when doing a 1031 exchange. This is true when you want to defer 100% capital gains tax due after the sale. However, if you choose to pay a portion of your capital gains tax, you will be able to keep a part of your proceeds.

There could be innumerable reasons why an investor wants to save cash. It could be for paying medical bills or for a vacation. No matter what, instead of refinancing, borrowing a new loan, withdrawing from a 401K or finding cash somewhere else, the investor can choose to sell a rental property and obtain the required funds from the sale of his property. A part of the proceeds can be taken out in case of an emergency, and the left proceeds can be reinvested into another like-kind property using a partial 1031 exchange. 1031 exchange rules do not limit an investor from completing an exchange if they don’t intend to reinvest entire proceeds.

The amount of cash you decide to keep in a partial 1031 exchange is considered boot. Here, the taxable boot has been anticipated and is acceptable; though in most cases 1031 exchange boot is an unpleasant surprise for the investor.

Boot is defined as “value received in addition.” In other words, you consumed your exchange funds and obtained other valuable things that did not comply with 1031 exchange terms; you earned cash, reduced the mortgage amount, or bought non-like-kind property with exchange funds. Though the resulting boot won’t put your 1031 exchange to end, the cash you used will be taxed.

Now I know that I can’t keep the cash after selling my investment property. However, can I cash out my equity without any tax consequences?

Maybe not. As per 1031 exchange rules, the equity amount in your replacement property must be equal to or greater than the equity amount in the property you relinquished. You may think that the $100,000 you want to keep from the sale was a part of the down payment you initially made to acquire your relinquished property, but the IRS will consider it as capital gains obtained from the sale.

Partial 1031 exchanges are beneficial for investors looking to liquidate cash. However, there are other reasons as well for considering a partial exchange:

  • Partial exchanges can help you compensate investment losses with gains obtained from the sale of your real estate.
  • Partial exchanges provide a medium to re-allocate investment funds. You can liquidate a few of your real estate holdings through a partial exchange and reduce the overall percentage of real estate you have in your investment portfolio.

If you don’t want to do a partial 1031 exchange, here are some general rules to keep in mind for deferring 100% capital gains taxes using a 1031 exchange:

  • The cost of the replacement property must be equal to or greater than the market value of your relinquished property. In other words, trade across or up, but never down.
  • The mortgage amount you withdraw to finance your replacement property must be equal to or greater than the amount owed on the relinquished property.
  • Total equity held on the replacement property must be equal to or greater than the equity held on the relinquished property.

Irrespective of the reasons you want to complete a partial 1031 exchange, it’s recommended that you have a word with a tax advisor prior to your investment to ensure you fully understand the tax consequences.

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