Strategy to Take Out Cash in a 1031 Exchange –Tax Free!

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Dan is a new client that I started working with just a few months ago.

He is an old timer in the real estate business and in fact Dan has owned most of his real estate for over 20 years. Almost all of his properties were single family rentals and many of which he bought for a super deal at around $40K to $70K each.

Considering the rise in market value since his original purchase it is safe to say that now each property is worth between $250K and $375K. Dan was nearing retirement age and when I met with him he told me that his goal over the next year or two was to sell his single family rentals and hopefully move his money into larger commercial deals.

His friends had invested in triple net shopping centers and the promise of fewer management headaches was something very attractive to Dan, especially since he and his wife were making plans to travel the world together.

Based on the appreciation, Dan was estimating a total of $1M in liquidity once he sold all of his rental properties. With the shopping centers he was hoping to invest in, he felt he would have some money left over which he intended to use to make some overdue improvements on his primary home.

What Dan forgot to account for in his plans was Uncle Sam’s portion of the gain. With the estimated sales price of his rentals, he was looking at long term capital gains of close to $750,000 with an estimated tax of over $100,000.

Prior to meeting with me, his old CPA had suggested a 1031 exchange as a strategy to reduce his potentially large tax bill. Since Dan’s plan was to re-invest the money back into investment property, a 1031 exchange made sense.

What he did not like was the fact that his old CPA also told him that he would not be able to take any money out to improve his primary home. In fact, any cash that Dan took out of the exchange would be subject to taxes even if he used the 1031 exchange strategy.

What is a 1031 Exchange?

A 1031 Exchange simply put is a tax deferred exchange.

Related: Don’t Pay Taxes on Your Capital Gains: 1031 Exchanges

This strategy allows you to sell one property and then using the proceeds to acquire another property during a specific time period. There is only one difference between doing this and doing a regular sale of a property and it’s that you must pay taxes on any gains you recognize while doing the exchange. Generally you can defer taxes on any gains. So simply put when doing a 1031 exchange, your sales are not taxable.

So why don’t all investors use 1031 exchanges to avoid taxes? Well, just like most other loopholes, there are rules you must meet in order to benefit from this tax break. Let’s take a look at the basic concepts for a 1031 exchange. In order for a 1031 exchange to be done correctly to minimize or avoid current taxes, these two rules below must be met:

  • The total purchase price of the replacement “like kind” property must be equal to, or greater than the total net sales price of the relinquished, real estate, property.
  • All the equity received from the sale, of the relinquished real estate property, must be used to acquire the replacement, “like kind” property.

In Dan’s case, the IRS doesn’t care that the property being sold is a single family and that the replacement property will be a shopping center. As long as they are both “rental real estate” he should meet the IRS definition of “like-kind” since he is selling one rental and replacing it with another rental.

For Dan, what he could do is sell a few of his single families and then use the total money from the sale toward the purchase of a shopping center, an easy way to delay the need to pay over a hundred thousand in taxes! What this means is that Dan can re-invest all his money back into real estate today without having to pay the government.

Taking Cash Out During a 1031 Exchange Tax Free

Now what about the fact that Dan was told he would not be able to take money out of the 1031 exchange to pay for the improvements of his primary home?

Well first off, Dan’s old CPA was correct in that you cannot exchange an investment property for a primary home as these are not considered “like kind” in the eyes of the IRS. However, while working with Dan we discovered anther potential loophole to help him save on taxes.

Related: BP Podcast 049: Real Estate Tax Tips, Jokes, and Loopholes With Amanda Han

Remember, earlier we said that in a 1031 exchange the replacement property’s purchase price and equity must be equal or greater than the property being sold. Well, what is not limited is the ability to refinance to take out money.

For example, if Dan finished out his 1031 exchange and met all the regular requirements, he should be able to refinance on the investment property and take out money to use for improvements on his primary home. Since the refinance is done outside of the 1031 exchange and after the exchange has been completed, Dan will generally not have any taxes due at the time he refinances on the shopping center.

In fact, what a lot of investors do not know is that the money pulled out via a refinancing after a 1031 exchange can be used for pretty much anything. That’s right…it does not have to be used for real estate. For example, if Dan wanted to use his money to buy a boat or go on his world trip instead of improving his primary home, he is able to do so without any current taxes due on the money he pulled out.

Of course, these types of transactions are highly complex and needs careful guidance prior to implementation. So if you are ever considering selling a property, be sure to meet with your tax advisor before you pull the trigger as there are many strategies that you may be able to use that can help you to defer or even permanently erase your tax bill.

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About Author

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

23 Comments

  1. So I had to read that entire post to learn that its possible to take out a mortgage on an investment property? Couldn’t he just borrow the money pre-1031 as well?

    • Rob: It is possible to simply refinance prior to doing the 1031x however you just want to make sure you strategize with your CPA on that to make sure you avoid the IRS collapsing this transaction as and then deem the refinance as boot and becoming taxable.

  2. Be careful with “cash-out” refinance strategies — the IRS calls it “boot” if done too close to the transaction.

  3. Amanda – Nice article.

    Rob – You would want to wait until after you close of the replacement property to start the refi process. You do not want to re-fi before and exchange, and when doing an exchange, in order to recieve full tax deferral, you must spend ALL of the cash proceeds.

    Ex. Sell for $1,000,000 and walk away with $750,000 cash, then purchase and spend all the cash and get another loan for $250, then you have full tax deferral.

    Sell for $1,000,000 and walk away with $750,000 cash, then purchase and take a loan for $750,000 and only spend $250,000, you are left with $500 in taxable cash boot….

    Tim – Can you point me towards an instance of this? There is nothing in the regs that say you cannot refinance after an exchange…

  4. As one currently going a 1031 exchange, I notice a couple of issues, if he wants to go from multiple properties into one wholly-owned property, he must sell all of his houses and acquire the shopping center within 180 days. Very difficult.

    There are syndications which allow 1031 funds on triple-net properties. With these, he could invest as he sells his properties, but he would have no control over refinancing.

    • Good point Jim. I have seen times where the seller or buyer involved in a 1031x lose a bit of negotiation power because they are “under the clock” for a transaction.

      With respect to syndications that is a little more difficult as a property cannot be replaced with an LLC interest (ie not like kind) which is how most syndications are set up.

      Thanks for the comment!

  5. Your very last comment about syndication and LLC’s… Does “like-kind” work if the funds move from LLC to LLC? What if each LLC has 4 partners pooling money. Could they each 1031 their own share of the profits from LLC to LLC?

    • Hi Rick: Thanks for your question. LLC interests are not considered tangible property so is not eligible for 1031X. The way around that is to distribute the properties out to the owners as tenants in common and then do a 1031X. Be sure to speak with your tax advisor if you plan on going down this route to make sure you have all your ducks in a row.

  6. I have heard that depreciation recapture is at a 25% tax rate, not a long term capital gains rate. Is the depreciation recapture tax rate dependent on income level? Or just 25%, or taxed like long term gains?

    • Hi Eric:

      Thanks for your email. Yes if a property is sold at the gain and it is long term gain then part of the depreciation recapture is at 25%. The rest is taxed at either 15% or 20% depending on the person’s income.

  7. Curious about Rick’s question, as I would like to know if I can do this. Do the LLC’s need to be with same syndicate/sponsor, or can the 1031 exchange be applied to any LLC with anyone, i.e. could I transfer from LLC-Company A to LLC-Company B? Thanks.

    • Hi Craig: Thanks for your comment…see above re: Rick’s question. In short LLC interests are not eligible for 1031X so if you wanted to invest in syndications or other group investments, you would need to take title of that as tenants in common with the other investors. The examples of 1031x being eligible for LLCs is within the same LLC: ie ABC LLC sells a home and buys a replacement home in ABC LLC.

  8. Hi Amanda,

    Thanks for this useful article.

    I have couple of questions related to this:

    1. Can I use both primary residence exemption and 1031 exchange? e.g. I purchased a property for 200K as primary residence; later moved out, rented and sold it for say 350K. Can I claim tax exemption for 250K due to primary residence and take remaining 100K and invest it somewhere deferred tax using 1031 exchange?

    2. If use that 100K to invest using 1031 exchange; can I do it under an individually owned LLC? i.e. primary residence was on individual name but investment is done under LLC strictly for liability purpose — can this be done with 1031.

    • Thanks for your question TJ. THe answer is yes it may be possible to do 1031 and use Sec 121 but there are quite a few rules surrounding that. I hope to write a blog on that in the next few months. In the meantime, here is a website that has some good examples: http://www.exeter1031.com/article_overview_1031_121_combination.aspx

      With repsect to question #2, I would suggest that the repalcement property also be owned by you personally and then you transfer it into an LLC for asset protection once the transaction is closed.

  9. Great Article Amanda do you happen to know how long do you have to wait after you do cash out to sell a property and do 1031 exchange to not consider it a “boot” by IRS. And also if you do take the cash out and later decide to do the 1031 exchange how much is actually considered gain as part of 1031 exchange the remaining amount of the new loan payoff and other closing charges or does it take into account the original purchase price as part of the considered gain for the transfer of 1031 exchange. Thanks again for the great article everyones comments and advices are appreciated on this. Thank You

    • Hi Raj:

      Thanks for your comment. There is no safe harbor on the time frame so it depends on the facts and circumstances. However Shaun has some great examples below in terms of 2 to 3 months is likely a bad time frame, a year+ may be ok, longer than that is likely even better.

  10. Interesting article.
    I’ve never done a 1031 but like learning about them as it is a strategy I want to employ in the future to move into bigger properties.

    A couple things I have seen before and some of which are mentioned in other comments that are unclear to me.
    – Refinance before the exchange: I have heard people advocate for and against this. Seems like if you do it far enough in advance it isn’t going to be an issue (as it is a legitimate transaction to do at various points in the investment cycle). If you do it the month before selling it will look like you are just trying to get around taxes, if you are doing it a year before selling then it looks pretty legit. In Dan’s case if he was looking to sell his stuff “in a year or two” he could probably refi one of them and pull out what he wants as a non-taxable event and is far enough ahead to not compromise the exchange.
    – Putting in all the cash received to the new property: I thought if you took any money out it was “boot” and it would be taxable but the rest wouldn’t be. In Dan’s case couldn’t he take what he needs and a little more to cover the tax but still be able to do the exchange? While taxable I will guess that the fees to refi a $1M+ commercial property will be significant.

    For your proposed idea is there a guideline to how long to wait to refi? Seems similar to doing it right before the exchange if you do it a month after purchase and cash out it looks like it is just to avoid taxes, which it is. I’d think minimally you’d want the new loan to have a better rate or some other terms to justify it past cashing out if you do it soon after.

    • Shaun: Great comment as always! Yes it is ok to have boot and pay partial taxes on the exchange while deferring the rest. Also what a wonderful point on the refi cost~! Awesome for readers to know that yes there is generally a cost to refi. For Dan, and actually I have seen this for a few clients, negotiation is very helpful. If you have multiple banks bidding for your loan then there are often lots of room to cut costs on a refi. You know what they say about negotiation being one the skill that can give you the highest ROI. =)

  11. Amanda, thanks for the great read. I actually just recently helped a family member complete a 1031 exchange in her mom’s estate. The estate had some properties but very little cash and she was looking at a very large capital gains tax bill if she sold the property and took her distribution in cash. (This was a 2010 Estate where the heirs had made an election to avoid estate taxes and not get a stepped-up basis.) When we researched this, we decided to do the exchange in the Estate, then let the property “season”, then distribute the property to her. We are now in the “seasoning” period but next year she will get the distribution and then do a refinance along the lines that you suggested.

    My question is, in our research, both with professionals and online, we found that any money she received from the future refinance would be subject to IRS rules of interest-tracing, otherwise the interest on the portion of refinance funds she used for personal use would not be deductible. Your post implies that this refinance money can be used for anything without a tax consequence. Did we miss something, or were you not considering the loss of deductibility in this case?

    • Hi Chuck:

      There is generally no interest tracing rules with respect to 1031x itself but it is a potential issue with flow through entities such as partnerships, LLCs etc. Essentially, if loan is used to take cash out of a property but funds are then distributions to the owners then interest tracing is generally done. I am not an expert on how 1031x are treated when the property remains within an estate but it is possible that this is similar to the interest tracing issues you are describing. If you have a tax expert assisting you with this then I would definitely rely on their advise.

  12. Hi Amanda,

    I own two rental properties, a condo that I own free and clear and a house that has $12K left to pay on the mortgage. I estimate that my gain on sale of the condo will be about $25K and I would like to shelter part of that gain by using a 1031 exchange. Can I use $12K of my gain on sale of the condo to pay off the remainder of the mortgage on the house under 1031, and then just pay taxes on the remaining $13K from the condo sale?

    The house was purchased in 1998 but I will not own it free and clear until the mortgage is paid off. Just wondering if this would qualify under 1031 as acquiring another rental property?

    Thanks!

    • Hi Jill: Unfortunately the 1031x is used when you sell a property and replace it with another rental property and it is also based on sales price…so if you want to avoid taxes on gain on sale of the condo, you need to find a replacement property with purchase price and equity of equal to or greater than the condo you are selling in order to get the tax-deferral treatment. Simply paying down debt of another property you already own does not equate to a 1031x. =(

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