You must meet certain requirements in order to defer 100% of your Federal, and in most cases state, capital gain and depreciation recapture income tax liabilities on the sale of your investment property. Generally, for full tax deferral, you must (1) acquire like-kind replacement property that is equal to or greater in value than the relinquished property sold (based on net sales price, not based on your equity); (2) must reinvest all of the net proceeds or cash (net equity) generated from the sale of the relinquished property; and, (3) must replace the amount of old debt that was paid off on the disposition of the relinquished property with new debt of an equal amount on the like-kind replacement property.
You can always infuse more cash into the 1031 exchange transaction but you cannot pull any cash out of the 1031 exchange without recognizing depreciation recapture and/or capital gain income taxes. For example, if you acquired property with a $60,000 cash down payment and you are now selling the property and are completing a 1031 exchange transaction, even the $60,000 initial cash investment must be reinvested in like-kind replacement property in order to defer 100% of your capital gain and depreciation recapture income tax liabilities.
The only way you can safely pull any cash out of your property without incurring a depreciation recapture and/or capital gain income tax liability is to refinance the property well before your 1031 exchange transaction starts or after you have completed your 1031 exchange by acquiring all of your like-kind replacement properties.
You can also purposely use the 1031 exchange to defer only a portion of your depreciation recapture and/or capital gain income tax liability. This strategy is generally used when you have other income tax losses than can be used to offset some of your depreciation recapture and/or capital gain income tax liabilities.
Trading down in value and/or pulling cash out of your 1031 exchange will result in the partial recognition of your depreciation recapture and/or capital gain income tax liabilities. The amount that is not exchanged for qualified like-kind replacement property is called cash boot or mortgage boot and will generate the recognition of your depreciation recapture and/or capital gain income tax liabilities.
It is extremely important that you consult with an experienced Qualified Intermediary (also referred to in the real estate industry as a 1031 Exchange Accommodator or 1031 Exchange Facilitator) and competent legal, tax and financial advisors for guidance in structuring your 1031 exchange transaction. There may be other income tax issues not related to your 1031 exchange that would affect your decision to structure your transaction as a 1031 exchange.
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