Are you interested in deferring your taxes when transitioning between investment properties but don’t want to reinvest all your cash proceeds into your replacement property? Don’t let the cash reinvestment requirement of a 1031 exchange discourage you. Cashing out is indeed possible, but the timing and method you choose can significantly impact the outcome.
With proper planning, you can potentially defer all your taxes and access the cash you need. In this guide, we’ll explore the distinct requirements and consequences of accessing cash before, during, or after your 1031 exchange.
Understanding 1031 Exchange Reinvestment Requirements
First, let’s briefly review the key requirements for a successful 1031 exchange:
Purchase a property with a value equal to or greater than your net sales price.
Utilize all the proceeds from the sale in the new transaction.
It’s the second requirement, reinvesting all cash proceeds, that may deter some investors from fully exploring this valuable portfolio-building opportunity. However, it’s essential to know that cashing out can be a viable option.
Regardless of your motivation, comprehending the rules governing cash access in a 1031 exchange can help you leverage this strategy while obtaining the necessary funds. In this article, we will delve into three main options:
- Cash-out refinance before selling (potentially risky if not executed correctly).
- Cash-out during the exchange (may trigger taxable “boot”).
- Cash-out refinance after selling (often recommended by tax advisors).
Cashing Out Through Refinancing Before Your Exchange
If you’ve recently refinanced your property for legitimate and well-documented business reasons, and you now intend to sell using a 1031 exchange, it’s important to understand that these separate business decisions will be considered if you undergo an IRS audit. For instance, many investors faced financial challenges during the pandemic and opted to refinance to stay afloat. Subsequently, they successfully completed a 1031 exchange shortly after. This unique and verifiable business emergency allowed them to both refinance and benefit from a 1031 exchange with full tax advantages.
However, it’s important to exercise caution when refinancing your property shortly before your exchange with the sole intention of extracting cash for personal or unrelated business purposes. This practice is strongly discouraged because the IRS has a consistent track record of associating such refinancing activities with the subsequent exchange, deeming it a taxable event through a step transaction analysis.
In the context of a 1031 exchange, strict adherence to all the rules is crucial to avoid incurring taxes. If you are knowingly attempting to circumvent the reinvestment requirements by withdrawing funds via a refinance immediately before the sale, the IRS has consistently classified this as “boot,” which is essentially cash taken out of the exchange. While most advisors are generally comfortable with refinancing for purposes unrelated to the business, provided it occurred a year or more before the exchange, it’s advisable to adopt a conservative approach by allowing at least two years between such a refinance and your planned exchange.
In legal proceedings, the IRS has effectively argued that refinancing before a 1031 exchange essentially constitutes the receipt of taxable boot within a staged step transaction. This argument is grounded in the principle of substance over form. Even though the cash is taken out before the exchange itself, the IRS contends that it is an integral part of your overall exchange process, effectively bridging the exchange.
To illustrate, the IRS might assert that, in an attempt to evade taxes, you extracted cash prior to initiating your exchange and then proceeded with the 1031 exchange to enjoy full tax deferral, despite having received untaxed cash. The IRS may argue that the chronological order of these transactions does not interrupt the step transaction, making their substance-over-form argument persuasive. Consequently, the cash extraction could be deemed taxable boot under the rules of a 1031 exchange, potentially placing the entire exchange at risk.
When facing an audit, engaging in property leveraging just before a 1031 exchange may trigger scrutiny. It’s important to note that a cash-out refinance is not advisable unless you can provide well-documented and compelling evidence to demonstrate that it doesn’t qualify as boot, which is taxable.
One of the significant challenges with pre-exchange refinances is establishing clear separation between the refinance and the exchange. To mitigate potential issues, it’s advisable to plan ahead and create as much temporal distance as possible between the refinancing and the exchange if you find it necessary to pursue this route.
Experts generally concur that refinancing your replacement property prior to the exchange can pose significant challenges, especially if an audit is a concern.
Accessing Cash During a 1031 Exchange
While obtaining cash during your exchange incurs tax liabilities, there are circumstances where this might be the most pragmatic choice, particularly if the purpose is personal rather than business-related. It’s crucial to recognize that such cash withdrawals during the exchange result in a partial exchange, with some funds being subject to taxation.
Accessing Cash After a 1031 Exchange
Although there is no clear-cut rule or provision addressing this scenario, the IRS has historically shown leniency regarding refinancing of replacement properties post-exchange. Nevertheless, as previously mentioned, it’s essential to ensure that this refinancing isn’t documented on the settlement statement of the property purchase.
Members of the Section of Taxation of the American Bar Association have offered their insights on this matter:
In the case of post-exchange refinancings, there should be fewer tax concerns compared to pre-exchange refinancings. The timing of the refinancing relative to the acquisition of the replacement property should not be a significant factor. Even if a new loan is secured at the time or shortly after acquiring the replacement property through a 1031 exchange, any cash received by the taxpayer should not be treated as a boot.
However, it’s important to note that there is virtually no established authority specifically addressing this issue. The key differentiator between pre- and post-exchange refinancings lies in the fact that, following the completion of the exchange, the taxpayer remains liable for repaying a post-exchange replacement property refinancing. In contrast, a pre-exchange refinancing of a relinquished property is typically relieved upon the transfer of said property. An essential principle supporting the argument that borrowing money does not generate income is that borrowed funds must be repaid, negating any net increase in wealth. This principle clearly applies in the case of a post-exchange refinancing, and there is no logical basis to categorize such financings as substitutes for fictional payments by the seller of the replacement property.
For instance, when you refinance just before selling through an exchange, you receive cash, which temporarily increases your wealth. However, as the debt associated with that cash is settled upon the sale, this increase is offset. In contrast, when you refinance after the purchase, the cash you receive is balanced by a corresponding debt obligation, resulting in no net gain in wealth.
While not foolproof, refinancing your new property remains the most advantageous method for accessing cash when executing a 1031 exchange. Even in this scenario, it’s crucial to:
Demonstrate that legitimate business reasons prompted the refinance.
In terms of preference among investors and experts, the options for extracting cash from your exchange are as follows:
A post-exchange refinance (tax-deferred)
Cash-out during the exchange (most suitable for personal use, but taxable)
A pre-exchange refinance (may jeopardize your exchange if not executed correctly)
The principal aim of a 1031 Exchange is to defer taxes during the transition from one investment property to another. While, in specific circumstances, a cash-out refinance before the exchange may be feasible, most experts advocate for extracting cash during the exchange for personal use and employing a post-exchange refinance for further investment purposes.
If you’re contemplating an exchange for an upcoming property sale but require cash, it’s advisable to engage in proactive discussions with your tax and legal advisors well in advance. This approach maximizes the likelihood of devising a successful exchange structure that aligns with your financial objectives.