1031 Exchange - Capital Gains

[Stephen Smith]

Hello - New to the board.  I am looking to sell a single-family rental property that I have owned for 3 years.   The house was purchased for $239k and is now worth approx. $439k.  There is no mortgage on the property.  My question is can I take out any of the funds from the proceeds as non-taxable if they are less than the purchase price?  Alternately, can I do a cash out mortgage prior to sale and still do the 1031 exchange and avoid capital gains?

[Dave Foster]

@Stephen Smith, Unfortunately @Wayne Brooks is correct (well not unfortunately Wayne is correct but unfortunately for you Wayne is correct.  Wayne is usually correct.  It's just unfortunate in this situation :)  I digress.

In order to defer all tax in a 1031 exchange you must purchase at least as much as you sell and use all of the proceeds.  so any combination of mortgage or purchase price that gives you cash at any point in the transaction creates a taxable event.  You would only pay tax on what you receive and still shelter the rest of your profit but there is a better way.

You're on the right track with your thought of a cash out refi.  But you absolutely do not want to do that prior to a sale.  the IRS has consistently ruled that a cash out refi closely followed by a sale and 1031 is the same as taking profit and they will disallow your exchange if audited.  

However - once you complete your purchase you can do a refinance after the fact and still get the cash out that way.  When done in this order you are no longer taking profit ahead of a sale.  You are borrowing against the equity.  The interest is deductible.  You get the cash.  And your 1031 remains totally tax deferred.  Not a bad way to go.