A common pitfall in 1031 exchanges arises when investors attempt to pull cash out of their properties right before or during a 1031 exchange. The IRS often views these maneuvers as the equivalent of “taking boot.”
One scenario is pre-exchange cash-out refinancing on the relinquished property:
If you refinance your relinquished property just before selling it, that refinancing can look like you are receiving proceeds from the exchange. In other words, it may be treated as taxable boot. The IRS has recognized limited exceptions in cases where the refinancing was truly unrelated to the exchange (for example, Fredericks v. Commissioner, T.C. Memo 1994-27 and Garcia v. Commissioner, 80 T.C. 491 (1983), Acq., 1984-1 C.B. 1). But in general, a refinance in anticipation of the exchange, especially right before closing, is highly risky and can undermine your tax deferral.
Another scenario is borrowing against the replacement property:
Similarly, loading excessive debt onto your replacement property can create problems. If you borrow more than is needed to close the purchase, you could end up receiving excess cash back at settlement. That cash is treated as boot, and it will be taxable. The safer path is to borrow only what is necessary to acquire the replacement property and avoid creating a cash-out situation.
Refinancing strategies that coincide too closely with your exchange can be seen as disguised cash-outs. Work closely with your qualified intermediary and tax advisor before considering any refinance in connection with a 1031 exchange.
Final Takeaway – Don’t Touch the Money
In a fully taxed-deferred 1031 exchange, you should never touch the money.
Whether you call it “constructive receipt” or “taking boot,” the principle is clear. If you end up with cash in hand, your tax deferral is at risk. Work with a qualified intermediary before closing to make sure the proceeds flow directly into the exchange process.
That one step protects your funds, preserves your tax deferral, and keeps your 1031 exchange on solid legal ground.
Defer Your Tax and Build Your Wealth Over Time with a 1031 Exchange
A 1031 exchange allows you to build your wealth over the long run by deferring your capital gains taxes on the sale of investment real estate. This powerful provision of the tax code is available for all United States taxpayers to use. You do, however, need to meet certain guidelines in order to defer 100% of your capital gains taxes. A qualified intermediary can help you navigate this process and ensure you defer your taxes. Contact CPEC1031, LLC today at our Twin Cities office to learn more!
Defer the tax. Maximize your gain.
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