Last month, I wrote an article about the reinvestment rules of a 1031 exchange. To pay zero tax in an exchange you must buy equal or up, and you must reinvest all of the cash. But what happens if you want or need some of the cash from your exchange? What are the rules you should be aware of?
Let's say that Fred and Sue are selling their purple duplex for $100,000. They found a new property, also for $100,000, and want to do a 1031 exchange. There is just one small hitch to their exchange -- they would like to use $5,000 of the sale proceeds to take a second-honeymoon cruise. Like most people, they assumed that since they had more than $10,000 of their own equity in the property, there would be no tax impact if they pulled some out when they sold it. They assumed that since it was their money it would be tax free.
Wrong! Any money you touch in a 1031 exchange will be taxable. And worse -- there are only two places in a 1031 exchange when you are allowed to touch your exchange proceeds. The second of these two places is at the end of your exchange. Once Fred and Sue's intermediary has their exchange proceeds, they will have to wait until the exchange is over to get their $5,000. This might be 180 days after the sale!
The definition of "over" in an exchange depends upon how Fred and Sue's intermediary drafts the documents for their exchange. Drafted one way, and they can have the unspent balance as soon as they purchase their replacement property. Drafted another way, and they will have to wait until the 180 day replacement period has expired.
Many intermediaries keep all, or the lion's share, of the interest earned on the exchange proceeds while they hold them. For this reason they will draft the exchange documents to require that any unspent proceeds must be held by them until the expiration of the 180-day replacement period. More reasonable intermediaries will draft the documents to state that once you have bought your intended replacement property, any unspent proceeds will be released to you. If you don't plan on spending all of your exchange proceeds, make sure that the intermediary you choose will release any unspent funds to you immediately after the purchase of your replacement property.
The more preferable way that Fred and Sue can get their $5,000 is at the closing of the sale of their old property (the purple duplex). You are not required to do a 1031 exchange on 100 percent of a property. You may choose to do an exchange on just a portion of it. The portion of the sale that is outside the exchange is taxable, of course, but it greatly increases your access to the cash.
Since Fred and Sue are selling the purple duplex for $100,000, but want $5,000 cash for their cruise, they could declare that they intend to do an exchange on only 95 percent of the duplex. The remaining 5 percent will be outside the exchange. At the closing, there would be two parts to their sale (almost as if there were two sellers): the exchange portion for $95,000 and the balance for $5,000.
In a situation like this, you need to make sure that the exchange documents are constructed correctly. Clearly show that only 95 percent of the sale is an exchange, and that the balance of $5,000 is not part of it. If the intermediary prepares the documents incorrectly, it gives the IRS justification to disallow the entire exchange. Since many intermediaries, especially the low-fee type, use preprinted, fill-in-the-blank exchange documents, it is your responsibility to make sure the documents are correctly prepared (or modified) to show this split sale. If you know on the front end that you want money from the closing of the sale of your old property, you'd be better off picking a good intermediary that understands what you want to do and how the documents need to be constructed.
Whether Fred and Sue take the $5,000 at the time of the sale of the purple duplex, or 180 days later when the replacement period has expired, the $5,000 will be taxable. Next month we'll talk about how you can get access to the equity in your property without it being taxable.