Have Your Cake and Eat It Too

Sell the property, defer the tax and keep some tax-free cash

1031 exchanges are wonderful things with lots of nuances most people don’t know about. One of those is the fact that you don’t have to do an exchange on the entire sale. Let me show you how to take that little nuance and use it to get some cash out of your sale without paying tax.

Let’s start with the assumption that you’re selling your rental duplex for $500,000. You have a substantial gain on this property and you want to buy another property with the proceeds. You intend to do a 1031 exchange so that you don’t have to pay tax on the gain, but you would really like to take some of that cash out to pay off one of your credit cards, or maybe even buy a car.

Start by looking at your tax situation. Do you have a passive activity loss carryover? Certain high-income taxpayers are not able to deduct all of each year’s loss on rental property. This loss is called a passive activity loss and it carries over to future years until you sell the property.

Let’s assume you have a $50,000 passive activity loss carryover on this property. In this case, you want to do a 1031 exchange on 90% of the property ($450,000), and you want the other 10%, $50,000, to fall outside the exchange. On the day of the sale, you’ll receive a check for $50,000, and the balance will be transferred to your intermediary for the purchase of the new property. At the end of the year, when your accountant prepares your tax return, the $50,000 will not be taxable because it offsets the passive loss carryover.

Taking a different example, let’s say you have a loss of $100,000 from some stock or other property that you just sold. Same concept: you do an exchange on 80% of the property ($400,000), and you take $100,000 out at the closing of the exchange. At the end of the year, the $100,000 gain from the sale of the rental is offset by the $100,000 stock loss with the end result that you end up with $100,000 in cash, tax-free.

These are just a couple of examples, but you get the idea. To see if this strategy can work for you, the place to start is with your tax return. By reviewing your return, or talking to your accountant, you can see if you have the capacity to absorb some gain, either tax-free or at a low tax rate. Determine this amount first and then work backwards into your exchange, subtracting the amount of gain you want from the selling price. This percentage gets taken off the top. Don’t worry about the basis because gain comes first in a 1031 exchange, meaning whatever you take out will be gain. If the gain you want to take out is as much, or almost as much, as your overall gain, you may not even need to do an exchange.

One last caution (and this is a BIG one!): while you are not required to do a 1031 exchange on 100% of a property, 1031 law prohibits you from touching any of the proceeds during the exchange. This makes it imperative that the exchange documents clearly differentiate the portion that is 1031 exchange, and the portion you want outside the exchange. You also want the exchange documents to clearly state that the cash you are taking out is NOT part of the exchange.

Many intermediaries handle 1031 exchanges as a sideline to their main business, like a title insurance company for example. They often use pre-printed ‘one-size-fits-most’ fill-in-the-blank exchange documents. If their exchange documents are not modified to show the portion of the property subject to the exchange and the portion that is outside of it, the IRS will most likely disallow your exchange in the event of an audit. And you will end up paying all that tax, plus the QI’s fees for handling (or mishandling) the failed exchange. If you’re dealing with one of those intermediaries, make sure they understand the changes you want made to your exchange documents, and that they properly make those nuanced, yet vital, ever-so-important changes to those documents.