Can I Take Cash Out or Take on Less Debt with My Replacement Property?

The general rule for complete tax deferral in a 1031 exchange is to buy replacement property with a value that is equal to or greater than the fair market value of the relinquished property and to reinvest all of the net cash received at the closing of the relinquished property into the replacement property.

 

For example, if the relinquished property has a fair market value of $1 million with a $200,000 mortgage, capital gains tax could be completely deferred with a 1031 exchange (assuming all other requirements are met) if the replacement property purchased is worth at least $1 million and the investor reinvests all of the $800,000 equity.  The debt of $200,000 on the relinquished property can either be replaced by the same amount of debt on the replacement property or the investor can contribute his own additional cash. 

 

What if the investor wants to take some cash out of the exchange or take on less debt and buy less expensive replacement property?   Generally speaking,  if you trade down in value or equity, the taxable gain will be the greater of the amount traded down in cash or traded down in equity, but in no event more than the gain that would be due if you didn’t do an exchange.  Knowing a few basics can help you determine whether a 1031 exchange would still provide a tax advantage.

 

RECEIVING CASH FROM THE SALE OF THE RELINQUISHED PROPERTY

 

We will stick with the same $1 million property referenced above. First, our investor needs to determine the amount of gain for the relinquished property.  Very generally, the gain is the difference between the sale price and the price originally paid for the property. So if the investor originally purchased the property for $600,000 and is now selling it for $1,000,000, the gain is roughly $400,000.  If the investor decides not to do a 1031 exchange and no other tax exemptions apply, tax would be owed on the $400,000.

 

Let’s say our investor wants to take out $100,000 of cash from the sale of the relinquished property. The investor could sell the relinquished property for $1 million, take $100,000 of the cash equity, reinvest the remaining $700,000 and take on more debt (to replace the cash he took out) to purchase a replacement property worth $1 million. Even though the replacement property is the same value as the relinquished property, the $100,000 cash taken out by the investor is considered “boot” and will be taxable.  The transaction still results in favorable tax treatment because the tax is only owned on the $100,000 boot, rather than the entire $400,000 of gain.

 

One point to consider on the above scenario is the timing of the payment of the $100,000 cash to the investor.  If the investor knows he wants to take cash out of the exchange, he should receive the funds directly out of the relinquished property closing. The balance of the proceeds should then be sent to the qualified intermediary to complete the exchange.  If the $100,000 is sent to the qualified intermediary with the remainder of the proceeds, that money will be subject to the federal tax regulations (Section 1.1031(k)-1(g)(6)) limiting when the qualified intermediary can release the funds. [See article Restrictions on Receiving Cash in a 1031 Exchange]  The result is that the investor may not have access to the $100,000 until the completion of the exchange.

 

TAKING ON LESS DEBT

 

Let’s say our same investor decides to take out $100,000 cash and decides he wants to reduce his debt obligation to $50,000 so buys a replacement property worth $750,000.  This purchase results in the same decrease in equity of $100,000 but also a decrease in value of $250,000 ($1,000,000 Rel. FMV - $750,000 Rep. FMV).  As stated above, the taxable gain will be the greater of the amount traded down in cash or traded down in equity, but in no event more than the gain that would be due if the client didn’t do an exchange. Here the investor will have to pay tax on the $250,000 difference between the value of the relinquished property and the value of the replacement property. The investor may want to proceed with the exchange because the tax impacts are still less than having to pay tax on the $400,000 of gain.

 

The numbers above are very general and do not account for certain factors like capital improvements, depreciation and exchange expenses.  Each situation is unique and we encourage all investors to consult with their tax advisors about their specific exchange transaction details.