The 1031 exchange is a wonderful way to shield a real estate investment from capital gains tax and depreciation recapture. When the time comes to access some of the money tied up in that investment, it is possible through the simple process of a partial 1031 exchange. It is not immediately possible, however; so you should plan for the occasion well in advance, and not count on that cash for emergencies.
A Partial Exchange Gives You Access to Cash
To defer taxation on an investment property completely, you have to leave all the money from your original investment in the deal when you carry out an exchange, and you must put any other cash you receive in the sale of the relinquished property into the purchase of the replacement. If you fail to do that, you get boot, which is taxable. Although this principle is simple, there are a few details to bear in mind. First, there are two kinds of boot—cash and mortgage. Cash boot is cash left over at the end of an exchange transaction; mortgage boot is a reduction in the debt on the replacement property in respect to the relinquished property. The intentional use of cash boot in an exchange is referred to as a partial 1031. Only cash boot will help you when you need cash in hand.
So, while the 1031 exchange is a mechanism to defer capital gains tax, you can take advantage of that potential and still access cash to use for other purposes (cash boot). Care must be taken to assure that your cash boot is enough to meet your needs. Cash boot can be created without the exchanger receiving any real cash. One of the ways this can happen is when sales proceeds are used to pay for unauthorized closing costs.
The way to make a partial 1031 exchange work for you is to plan thoroughly. When the sales arrangements are made ahead of time, you can avoid technical pitfalls and receive the cash you seek much faster. If you are able to specify the amount of cash you want to remove from the exchange transaction at the time of the relinquishment sale, you can stipulate that you should receive that amount at closing. Alternatively, if you are able to identify the single property that you will buy when you make an agreement with your qualified intermediary (QI), you can receive the cash boot at the time the replacement sale closes.
Expert Advice Can Make a Big Difference
Few investors are able to make provisions for a partial 1031 exchange without expert assistance in identifying a replacement property, calculating the amount of cash boot to take, and wording the exchange agreement with the QI. Without that level of organization to make the advance stipulation, you have to wait 181 days (per IRS regulations) to receive it from the QI.
Another strategy for receiving cash from a 1031 exchange is to exchange 100% of your sale proceeds into a replacement property and then complete a cash-out refinance. In this case, there will be no capital gains tax or depreciation recapture since you are not receiving any income. Rather, you are increasing your debt.
To receive cash from a partial 1031 exchange relatively promptly, and not increase your debt, expert planning is crucial. Consider also that a partial 1031 exchange is useful when an investor wants to take a relatively small portion of the equity out of a deal. When the cash boot approaches or exceeds 50 percent, it is not always expedient to use the remaining funds in a 1031 exchange. This is a complex calculation that is best made with the help of an accountant or investment adviser.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country, and employ a team of experts who can help you hone your investment strategy.
For more articles like this one, check out our 1031 exchange blog posts.
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