We are often asked if property can be exchanged and still provide some cash for other immediate needs? The short answer is yes, however, If you elect to take cash, it will be immediately subject to significant tax.
The very tax you are trying to avoid is triggered (up to the amount you touch) at the moment cash is received. This can prove to be a rather costly option as Federal capital gain rates can take a 23.8% swipe (depending on your income) and state tax (depending on where you live) will also be due. So although it is possible to take cash out at closing it is not recommended.
The first thing to remember if you want tax deferral is NEVER touch the cash. That includes never taking possession of the sale proceeds at the closing table or allowing your attorney or other agent to do so. All sale proceeds MUST be directed to your qualified intermediary (QI).
If you have cash left over after the QI funds the acquisition of your replacement property, it will paid over to you at the end of the exchange or 180 days, whichever comes first. That cash, known as “boot” will be taxed as partial sales proceeds from the sale of your property, generally as a capital gain by both the state and federal government at the above mentioned rates.
Don’t forget to factor in existing debt!
Besides taking cash, one of the main ways people get into trouble with 1031 transactions is failing to consider their existing loans. Mortgage loans or other debt on the property you relinquish, and any debt on the replacement property must be replaced with new debt. If you don’t receive cash back but your liability goes down, that too will be treated as income to you just like cash. For example, suppose you had a mortgage of $1 million on the old property, but your mortgage on the new property you receive in exchange is only $900,000. This will be treated as if you have $100,000 of gain (classified as “mortgage boot”) and it will be taxed at the same rate as cash proceeds.
The bullet proof test for 100% tax deferral is to always go even or up in value and replace the old debt with new debt or cash. Not sure, just ask, our goal is to keep you tax deferred!