Can I Take Cash Out of My 1031 Exchange?
**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**
Yes, you can take cash out but often at a price, i.e. taxable boot received. A boot in a 1031 exchange is money or the fair market value of other non-like kind property received by you in an exchange. Its receipt may trigger capital gains, depreciation recapture, state, and alternative minimum taxes. Reason aplenty to avoid boot unless something really lucrative or important outweighs it.
After all, the whole point of a Section 1031 exchange is for you and the other party to defer taxes with a like-kind property exchange.
You’ll have three exchange stages–before, during, and after–within which to take cash out of your 1031 exchange. We will cover them and also the same stages in a partial exchange.
Which option you choose and how it’s executed may be quite consequential. We’ll show why that’s so with explanations of cash-out ground rules and what inherent 1031 pitfalls to avoid.
Taking Cash Out Before a 1031 Exchange
You may be thinking about borrowing from appreciated property before sold via an exchange. You’ll want to do your best not to raise boot avoidance suspicions with the IRS.
A lot depends on when and under what circumstance refinancing is undertaken. Convincing, mitigating factors arguing against tax avoidance motivations will greatly improve success rates. Also helpful is putting as much time as possible between refinancing and exchanging.
The IRS may contend that cash from your refinances is essentially receipt of taxable boot in a staged step transaction. It’s a well-established IRS substance-over-form argument. Taking cash off the table while in the exchange is taxable boot. The same steps would be taken whether cash is taken before, bridging, or after the exchange.
Just to avoid tax the IRS might argue, you’re taking cash out in advance of your exchange. Then you plan to receive full tax deferral despite receiving untaxed cash. Nice try the IRS may contend, but just bridging the start date doesn’t interrupt the step transaction. Substance trumps form, i.e. with cash-out comes taxable boot under 1031 rules.
So, one of the big challenges in the pre-exchange refinancing process is to show separation from the upcoming exchange. Good planning will put as much time between refinancing and the exchange as feasible.
It’s a no-brainer to see why going immediately from refinancing to exchanging begs the question. In any event it’s critical that you garner plausible evidence to refute any claims of tax avoidance motives. Steps taken independent of the exchange need to be disclosed. Mitigating circumstance prompting refinancing are essential to building your case.
Perhaps you were experiencing a cash flow downturn requiring a cash infusion. Unforeseen events such as the pandemic or storm damage costs drained cash. That will divert attention from tax avoidance motivations to legitimate business purposes for refinancing.
As case law and other examples that follow suggest, establishing independence between transactions could overcome quick turnovers from refinancing to exchanging. By demonstrating step transactions were disrupted by independent actions, the substance-over-form argument works for rather than against you.
The following case law and rulings focus on whether taxpayers have adequately established motives for refinancing other than tax avoidance.
- In Fredericks v. Commissioner, Tax Court Memo 1994-27 cash received by the taxpayer from refinancing of relinquished property was allowed to escape boot. The Court found the refinancing to be independent of the 1031 exchange. It was not conditioned on the closing but rather was dependent on the taxpayer’s credit worthiness. The Court noted taxpayer several attempts to refinance the property over a two-year period before its sale. Refinancing was also made far enough in advance of the exchange to satisfy the Court.
- In Private Letter Ruling 8434015 the IRS ruled that a proposed refinancing’s proceeds received just before the exchange date would create taxable boot. In this case, not having established independence between the proposed refinancing and the exchange was the critical factor.
- In the court case of Phillip Garcia v. Commissioner, 80 TC 491 (1983), aff’d. 1984 -2 CB 1, the seller of the replacement property increased its debt just before the exchange. The intent was to equalize the liabilities on the two properties. The IRS contended that the mortgage increase was a step transaction that should result in boot being received by the Exchanger. They argued pre-exchange debt was increased merely to avoid tax. However, the Court rejected the IRS’s position, finding that the replacement property mortgage increase had independent economic substance.
However, despite some success pre-exchange, the consensus among most experts is refinancing your replacement property post-exchange is preferable. The hurdles are lower with the IRS largely acquiescing on refinanced replacements post-exchange. This is especially true if it’s late in the game for refinancing per-exchange since the exchange starts soon. Or should little persuasive evidence exist arguing against tax avoidance.
Taking Cash Out During a 1031 Exchange
As cited in the Introduction, any amount paid to you at closing may be subject to capital gains, depreciation recapture, State, and alternative minimum taxes. Section 1031 rules impose boot when more cash is borrowed than is needed to acquire replacement property.
One exception is improving properties via improvement/construction exchanges. Otherwise, at closing any remaining exchange proceeds returned to you creates boot.
The only question is when will it be refunded. When engaging your intermediary, be sure the agreement stipulates such funds are released promptly. You or your advisor will want to choose among the best 1031 exchange companies who have successfully dealt with issues you expect to face.
Then have intermediary consent written into the agreement releasing cash immediately upon purchasing replacement properties. Otherwise some intermediaries will hold the cash for the full 180 days replacement period before releasing the funds to you. All the while interest accrued on the escrowed funds may go to the intermediary per agreement.
Clear-cut as taxing cash-out is at closing, not many court cases bear directly on this issue. In Behrens v. Commissioner, Tax Court Memo 1985-195, 49 TMC 1284 (1984), the court held the Exchanger to have received taxable boot. Cash was received at closing on the replacement property. Purchase money for the Exchanger to finance the replacement property had been increased. That reduced the down payment required of the Exchanger. A taxable cash refund ensued.
In the Court’s dicta (remarks), the Judge observed that the taxpayer could have avoided boot. The implication was refinancing before or after a 1031 exchange would have negated boot.
To better understand what Qualified Intermediary is and what they do for you, read our article All About 1031 Exchange Accommodators (aka Facilitators or Qualified Intermediaries).
Taking Cash Out After a 1031 Exchange
Replacement property refinancing post-exchange should not cause tax issues. Doing so does nothing to jeopardize the tax deferral.
It should be kept off the replacement property closing statement, however. This is a reversal from relinquished properties where Exchangers will have loan debt paid off on closing. On replacement loans, debt obligations are retained by Exchangers effectively offsetting the receipt of cash.
- In the IRS’ Private Letter Ruling 200131014, the taxpayer refinanced replacement property after the exchange. The proceeds were used to advance business purposes. Noteworthy perhaps is refinancing occurred in the next taxable year following the exchange.
- Regarding this issue, the American Bar Association Taxation Section commented: Post-exchange refinancing should be of less concern from a tax perspective than pre-exchange refinancing. Here the integration of the refinancing with the acquisition of replacement property should not matter. Even where a new loan is obtained at the time or immediately following a taxpayer’s acquisition of replacement property in an exchange, receipt of cash by the taxpayer should not be treated as boot.
Coming from the ABA, that’s a reassuring endorsement. There’s little doubt financing the replacement property is less risky, but not failsafe. Here are some rules to consider when refinancing. You should:
- avoid appearances that it’s a tax avoidance ploy
- keep refinancing transactions apart from all other transactions to avoid interdependence
- assemble and maintain a paper trail to support independent transactions
- always be able to demonstrate refinancing had an independent business motivation.
There are 1031 incentives for going this route, as well. Uses of this post-exchange cash-out are not restricted. This exchange allows you to preserve equity through full tax deferral. With those immediate savings, you as an investor may diversify investments or reinvest in other assets of your choice.
But with the new debt obligation equaling the loan amount, your wealth is not increased. That’s a measure the IRS looks to in its substance over form argument. It’s likely why there’s been no challenge here to post-exchange refinancing.
Taking Cash Out of a Partial 1031 Exchange Exchange
There’s no requirement that you include 100% of the property in the exchange. It’ll be like having two sellers, i.e. the cash-out seller and the exchange seller. As always, any cash you receive is taxable. Otherwise, there are no big rules changes for the remaining portion under 1031.
For example, you sell rental property for $1M, but want $100,000 in cash. You may specify in the exchange agreement that 90% of the rental is to be included in the exchange. The remaining 10% will remain outside the exchange. At the closing, there would be two parts to the sale. There is the exchanged portion for $900,000 and the cash-out one for $100,000.
In a situation like this, you need to make sure that the exchange documents are drafted correctly. They should clearly show that only 90% of the sale is an exchange, and that the balance of $100,000 is not part of it.
An error here by the intermediary could cause the IRS to disallow the entire exchange. Finally, though it is your responsibility to ensure documents are correctly prepared to show split sales.
Again, upfront it’s a good idea to check out intermediaries’ qualifications and terms. There may be significant differences.
Some retain most of the exchange proceeds (including interest accrued) for the entire 180-day period. Others will disburse unspent cash to you immediately after closing on the replacement property. Choose one with terms and experience that best suits your objectives.
The Most Important Points
It’s important to distinguish differences between refinancing relinquished properties, pre-exchange and replacement properties, post-exchange. Clearly the stronger case is for post-exchange refinancing undertaken in a separate transaction. Less risk with cash-out funds to be utilized as you see fit.
Refinancing relinquished property pre-exchange isn’t precluded. Under the right circumstances, it’s viable.
In the Fredericks v. Commissioner court case cited earlier, relinquished property refinancing was found to occur independent of the 1031 exchange. It noted taxpayer attempts to refinance the property over a two-year period before its sale. These prior loan attempts demonstrating transactional independence from the exchange were instrumental.
With this kind of evidence and timing, success is possible here. However, in the absence of compelling factors and timing, most experts recommend the post-exchange route.
Admittedly little legal authority exists here. Perhaps it’s because the IRS seems to have tacitly accepted a key pre- and post-exchange refinancing difference.
To reiterate, replacement refinancing leaves you responsible to repay that loan. There’s no increase in your wealth but you’ve retained full tax deferral. To be reminded, the whole point of a Section 1031 exchange is for you and the other party to defer taxes with a like-kind property exchange.
It’s a complex process, however. If you are contemplating selling a property, seeking professional advice now may be a wise decision. As often pointed out here, taking relevant actions when possible well before starting an exchange may ensure success.
How to Ensure Your 1031 Exchange Is Legal and Safe?
Unless you are conducting a simultaneous exchange, you must use services of a qualified intermediary. A professional, competent, and experienced 1031 exchange company with income tax experts on the team will advise you and your CPA/tax advisor on when and how it’s best to take cash out of your 1031 exchange so that the tax authorities will not have a reason to deem it a tax avoidance attempt.
The professionals will consult you and your tax advisor/CPA on all factors and procedures that must be considered before and after it.
PropertyCashin is an all-in-one platform for commercial real estate investors that maintains relationships with top-rated 1031 exchange firms in all locations of the USA. To get connected with the best professionals and have your exchange processed safely and effectively, fill out the form below.