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April 8, 2014

Taking Cash Out before, during and after a Section 1031 Exchange (Part 2 of 4)

#1031 Advisor

Last week, we discussed the first of eight most common methods used to take advantage of the equity in a property sold in a like-kind exchange. Today we look at the next four.

  1. Borrowing from appreciated property and using the funds to acquire new property.
    Owners that are not selling an existing appreciated property can borrow against the equity in an appreciated property and use the funds to acquire another investment property. There is no tax consequence from borrowing against the appreciated property and the interest would be deductible under Section 163(d)(1) to the extent that the property produced investment income. If the property does not produce investment income, the interest deduction is suspended and carried forward to the next taxable year with investment income, including gain from the sale of the investment.
  2. Borrowing from appreciated property and using the funds for non-investment purposes.
    Owners can borrow against the equity in an appreciated property and use the funds for other non-investment purposes. However, interest paid on funds used for non-investment purposes is not deductible.
  3. Taking cash off the table at the time of the sale.
    Taking cash at closing is a taxable event and is taxed at the highest rate of tax applicable to the transaction. The highest rate of tax applies to the first dollar received by the owner. Note that taking cash at the time of closing does not disqualify the entire exchange, unless the taxpayer violates the constructive receipt rules.
    1. For example, on the sale of a particular investment property, the potential gain is $500,000, and the owner takes $50,000 at closing. The overall tax for the sale is:
      • $20,000, taxable at 39.6% as 1245 depreciation recapture;
      • $80,000, taxable at 25% as 1250 depreciation recapture; and
      • $400,000, taxed at 23.8% as capital gains.
      The $50,000 received at closing is taxed at 39.6% on the first $20,000 received and $30,000 is taxed at 25%.
    2. Care should be taken to indicate that the balance of the proceeds (including the $450,000 of gain) is properly assigned to the Exchange Company, not the entire proceeds. A California case recently invalidated an entire exchange under the principle that taking $50,000 violated the G-6 regulations which does not permit the taxpayer to receive any of the proceeds once they are assigned to the Exchange Company.
  4. Borrowing against cash proceeds held by the Exchange Company.
    Occasionally, we will get a question about the lender requesting to either hold the proceeds or to receive a collateral security interest in the sale proceeds based on the financial profile of the client. If the client is deemed to provide a collateral security interest in the exchange proceeds before the replacement property is acquired, the tax regulations provide that the exchange will be treated as a taxable sale and not an exchange.
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