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Cash Available from 1031 Exchange


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After a tax-free exchange, taxpayer invades equity to withdraw cash. Sorta defeats the "boot" definition.

Maybe an example can paint the picture, with simplified fictitious numbers.

Taxpayer owns Property 1 with a basis of $250,000, but FMV of $1,000,000 and existing mortgage of $85,000 which does not transfer to the buyer. He buys Property 2 for $1,000,000 and borrows $150,000 in the process. The sale/purchase goes through a qualified intermediary within the prescribed time limits, so BINGO! Tax free exchange!

Taxpayer sits on Property 2 for awhile, but six months later, he takes out a loan from the equity in the new property in the amount of $500,000, and doesn't use the money for improving Property 2 at all.

Does this scenario result in taxation?? Keep in mind that he had this same equity in the original property so it would appear he has the right to do this. But also, he is walking away from this tax-free transaction with a bunch of money...

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16 minutes ago, Corduroy Frog said:

Taxpayer owns Property 1 with a basis of $250,000, but FMV of $1,000,000 and existing mortgage of $85,000 which does not transfer to the buyer. He buys Property 2 for $1,000,000 and borrows $150,000 in the process. The sale/purchase goes through a qualified intermediary within the prescribed time limits, so BINGO! Tax free exchange!

In this scenario, taxpayer has a taxable gain because net equity in new property is less than net equity in the property given up.

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44 minutes ago, Corduroy Frog said:

Taxpayer sits on Property 2 for awhile, but six months later, he takes out a loan from the equity in the new property in the amount of $500,000, and doesn't use the money for improving Property 2 at all.

Does this scenario result in taxation?? Keep in mind that he had this same equity in the original property so it would appear he has the right to do this. But also, he is walking away from this tax-free transaction with a bunch of money...

IRS could view this as tax avoidance by pulling money out so soon after the 1031 exchange, and especially since the funds weren't being used to further the business purpose of this property.  The taxpayer certainly can borrow more or refinance, but the longer between the exchange and borrowing, the better.  Better yet would be that the borrowing not occur until a subsequent tax year.  AND, the taxpayer should also have meticulous records of how the funds were used for the property in order to justify the transaction. Six months seems too close for comfort.

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1 hour ago, mircpa said:

1,000,000.00 sales proceeds from property A used to buy property B for same amount

How 150,000.00 borrowed money becomes taxable ?

Rules of 1031 exchange:

  1. like-kind
  2. timing
  3. value
  4. debt
  5. equity

In the scenario provided by C.Frog, we'll assume that #1 & 2 have been met.  #3 value seems ok, as you say, both properties have the same FMV.

#4 - debt. Taxpayer is OK with debt because debt is at least as much as the debt on old property, BUT this increase in debt is causing a problem with #5 that deals with equity.

#5 - the net equity in the new property must be at least as much as in the old property. Net equity in old property is $i million - $85K = $915K.  Net equity in new property must be at least as much as that, and it isn't. Net equity in new property is $1 million - $150 = $850K. 

In order to meet the requirement of #5 in the scenario as written, if a replacement property of exactly $1 million (the same as old property) is to be obtained then the debt can't be more than the $85K, OR if the TP ends up with the higher debt of $150K then a property with FMV of $1,065,000 would need to be purchased in order to have net equity in the new property of the same $915K of property given up.  One way to help avoid this problem is to always trade up and expect to bring some cash to the table for closing. 

In the fictitious example provided, both properties were the same value but borrowing increased by $65K (150K new borrowing - 85K old borrowing).  Another way to look this same $65K is that that is the decrease in net equity of $915K of the old property to the new one's equity of $850K.  (915-850 = 65K) 

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Thank you Judy - and equity is one thing that hasn't been considered.  I am guilty of ignoring this factor as well.   I apologize for presenting fictitious numbers because I wanted to focus on the invasion of Property 2 of $500,000.  The real numbers are as follows:

Value of Property #1 - $925,000 with $90,000 still owed.  Equity $835,000.  The $90,000 mortgage is NOT being transferred to the new buyer.

Value of Property #2 - $975,000 with $140,000 owed.  Equity #835,000.  Taxpayer has to borrow the $140,000 to keep from investing more cash.

I am on board with Judy's caution for borrowing another $500,000 against Property #2.  This creates a sort of "boot" which is back-door from the original transaction.  If he borrows this money soon after trading, he needs to spend it on improving Property #2, but he tells me he would use the money to buy adjacent rental property.  This might be OK too.  But if he uses the money to buy a boat or something else non-business for personal aggrandizement, I definitely think there is a problem.

Apologize for the misleading fictitious information.  Judy is correct about equity.

 

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Oh, I didn't say he couldn't ever borrow against the property, but it shouldn't be done simultaneously or very soon after the exchange. Borrowing is certainly allowed, but there shouldn't be the appearance of borrowing so soon as to seem like immediately pulling out more equity. 

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9 minutes ago, jklcpa said:

Oh, I didn't say he couldn't ever borrow against the property, but it shouldn't be done simultaneously or very soon after the exchange. Borrowing is certainly allowed, but there shouldn't be the appearance of borrowing so soon as to seem like immediately pulling out more equity. 

Understand completely.  We want to avoid the appearance of "back door boot".  He has other rental property, and if he does this, it will probably be used to improve other rental property or maybe buy more.  If he waits a couple years, he will probably be off the radar, regardless of what the proceeds are used for.  Thanks again - you are absolutely magnificent in researching and answering these questions.

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