Most real estate investors opt for a 1031 exchange to avoid paying capital gains taxes. However, many are still determining if they could take out a small amount of cash while conducting this tax-deferred exchange. So, can I take cash out of my 1031 exchange?
Can I Take Cash Out of My 1031 Exchange?
Yes, you can take cash out of your 1031 exchange. This money received is called a boot and is subject to capital gains, depreciation recapture, and state and alternative minimum taxes. This process is known as a partial 1031 exchange and follows the rules of a standard 1031 exchange transaction.
A Qualified Intermediary (QI) holds the proceeds from the relinquished property sale and distributes the excess cash. However, you will only receive these funds once you close on the replacement property. After which, you must proceed to pay taxes on the cash received.
How to Take Cash Out of Your 1031 Exchange
Since there is no rule mandating that you include 100% of your sales proceeds in a 1031 exchange, it is pretty easy to take cash out. All you need is to send written instructions to the Qualified Intermediary requesting that you want to receive a percentage of the proceeds from the relinquished property sale.
If you sell a property for $500,000 and want $50,000 in cash, you should highlight in the exchange agreement that 10% of the proceeds should remain outside the exchange, and the remaining 90% should be included in the exchange. This means that there would be two parts to the sale at closing.
When doing this, make sure that the exchange documents are drafted correctly. Any mistakes by the intermediary could prompt the IRS to disapprove the exchange. Thus, you must be sure of the intermediary’s qualifications before working with them. Also, consult a real estate professional like Si Vales Valeo Real Estate to review your options and guide you through the commercial real estate transaction process.
Stages of a 1031 Exchange Within Which You Can Take Cash Out
As stated earlier, taking cash out of your 1031 exchange provides investors with a fair market value of cash. You can use this cash for personal purposes or invest in other assets that may produce significant returns. If you want to take out some cash, here are three stages within which to take cash out of your 1031 exchange:
- Before the 1031 exchange
- During the 1031 exchange
- After the 1031 exchange
Before the 1031 Exchange
You can receive a part of the proceeds from your relinquished property sale before conducting a 1031 exchange to defer paying taxes on the rest of the proceeds. This fund will be held by a Qualified intermediary and will be given to you once you close on the replacement property.
During the 1031 Exchange
You can also receive funds during the 1031 exchange when no replacement property has been identified within 45 days from the relinquished property sale. According to Section 1.1031 of the U.S. Treasury Regulations, the taxpayer cannot receive, pledge, borrow or otherwise get the benefits of money or other property before the end of the exchange period.
Therefore, a QI will not release exchange proceeds within the 45-day identification period except for a purchase or deposit on a replacement property under contract. If this period elapses and you have identified no property, the qualified intermediary can return the exchange proceeds.
After the 1031 Exchange
The qualified intermediary can release funds to you after the replacement property has been purchased and you have settled all closing costs. Depending on the QI, this can occur immediately or after the 180th day of exchange. You can also receive your funds if the transaction fails because of a seller’s non-compliance before the close of escrow.
1031 Exchange Timelines
1031 exchanges must abide by specific rules to be approved by the IRS. If you’re looking to take cash out of your 1031 exchange, here are two major timing rules you must observe:
- The 45-day rule
- The 180-day rule
The 45-Day Rule
The 45-day rule relates to the identification of a replacement property. It states that the exchanger must identify a maximum of three like-kind replacement properties within 45 calendar days following the closing of the sale of the relinquished property.
After the relinquished property has been sold, the qualified intermediary receives the cash and holds on to it until 45 days have passed. This implies that if you do not remove the cash you want before the 1031 exchange, you’d have to wait for the 45 days to be over before getting it.
The 180-Day Rule
The 180-day rule relates to closing the replacement property. It states that you must close the sale of your identified properties within 180 days of the sale of the relinquished property. This period runs concurrently with the 45-day rule, meaning that if you identify a replacement property 45 days later, you’ll have 135 days left to close on it.
This implies that if you do not remove the cash you want after the 45 days, you’d have to wait for the 180 days to be over before getting it.
Can You Do a 1031 Exchange on a Second Home?
1031 exchanges can only be conducted for income-generating real property. Therefore, a second home may not qualify for a 1031 exchange, except if it is held for investment and income generation.
Can You Give Out a 1031 Exchange Property?
Yes, you can give out a property acquired through a 1031 exchange. However, it should come with some caveats. Be sure to satisfy the holding requirements before giving out the property. Also, don’t give out the property if it’s newly acquired or the exchange intending to hold the asset as an investment property is not completed.
How Long Should You Wait to Refinance 1031 Property?
You should wait 6 to 12 months before attempting a refinance transaction on a 1031 exchange property. However, the longer you wait after the exchange is completed, the better.
It is possible to take out cash from your 1031 exchange and proceed with the tax deferral process. This process could be beneficial depending on why you take out the cash. However, it comes at the price of paying taxes on the cash taken out.