The 1031 exchange is considered a real estate property swap. Through the process, you’re trading a relinquished property for a replacement property of equal or greater value as long as proceeds from the relinquished property sale are directed to the replacement property’s acquisition.
But in addition to using those proceeds, can you add cash when closing on that replacement property purchase? The answer is yes—sort of. Using cash directly in an exchange could trigger tax issues. However, it’s possible to leverage cash as part of the exchange in certain situations.
You Can’t Touch the Cash . . .
The one issue that can’t be violated with a 1031 exchange is that you are never in control of the cash when your relinquished property closes. If any proceeds from that sale go to you, the IRS considers the exchange incomplete. This can mean you’re liable for capital gains and depreciation recapture taxes.
To comply with IRS regulations, you must work with a Qualified Intermediary (QI) when conducting a like-kind exchange. This entity manages the transaction and takes control of the proceeds from the sale of the relinquished property. The QI then pays your replacement property’s seller with that money.
In addition to using money generated from a real estate property sale, you can use cash to pay for your targeted replacement property. This can be useful if the replacement asset is worth more than your relinquished property. Or you might want to use cash to increase the replacement property’s basis. This can help increase depreciation deductions at tax time.
However, if you travel on this path, be aware that using your cash with the exchange process doesn’t generate a tax-deferral benefit. Only proceeds from the relinquished property’s sale qualify for tax deferral, assuming they’re used to buy the replacement property.
You might decide that a partial exchange is a good idea. This occurs when you reinvest only part of the sales proceeds from your relinquished property into the replacement property. A partial exchange can be helpful if you have an urgent cash need or want to reduce your debt. The extra cash could also diversify your portfolio and spread risk.
The cash you receive, in this case, is called “boot.” And that boot, unlike the proceeds invested in a replacement property, is subject to capital gains and depreciation recapture taxes. Remember this if you decide to take part of your relinquished property’s proceeds as cash.
Extra cash in a like-kind exchange can be a viable strategy, whether increasing the basis of a replacement property, taking money out to lower your debt load or reinvesting elsewhere. However, it’s important to understand that adding or removing cash with an exchange can have tax implications.
Given the complexity and stringent rules involved with property exchanges (with or without cash), your team should include a qualified tax expert and intermediary. These individuals can help you avoid mistakes and guide you in the right direction.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.