A 1031 exchange offers real estate investors the opportunity to defer capital gains taxes by reinvesting proceeds from the sale of an investment property into a new, like-kind property. The process can significantly enhance an investor’s ability to build wealth through real estate by keeping capital working for future growth. However, many property owners wonder whether they can keep a portion of the proceeds from the sale while still completing a valid exchange.
How a 1031 Exchange Works
A 1031 exchange is designed to allow an investor to defer paying capital gains taxes that would normally arise when selling an investment property. The Internal Revenue Code permits this deferment only if the sale proceeds are used to acquire another property of equal or greater value for investment or business purposes. To comply with the requirements, all proceeds from the sale must generally be held by a qualified intermediary—such as 1031 Federal Exchange—who manages the transaction and ensures that the investor does not take direct possession of the funds during the process.
The purpose of these strict requirements is to ensure that the funds remain within the exchange process until they are used for reinvestment. If the seller receives or controls any part of the sale proceeds, those funds are considered “boot,” a term used to describe any money or non-like-kind property received in a 1031 transaction. Boot is taxable and can reduce or eliminate the tax deferral benefit of the exchange.
When and How Funds Can Be Retained
It is possible, under certain circumstances, to keep a portion of the funds from a 1031 exchange. However, doing so has clear tax consequences. If an investor chooses to withdraw part of the proceeds from the sale, that portion will be treated as taxable gain. The remainder of the proceeds used in the exchange may still qualify for deferral, as long as all other requirements are met.
For example, if an investor sells a property for $1 million and only reinvests $900,000 into the replacement property, the remaining $100,000 would be considered boot and taxed accordingly. This allows some flexibility for investors who wish to access part of their equity while still taking advantage of the exchange for the majority of their proceeds. However, investors must plan carefully to ensure that the retained amount does not disrupt the overall compliance of the transaction.
Timing is also critical. Funds cannot be withdrawn while the exchange is still in progress. The qualified intermediary must hold all proceeds until the exchange has been completed or terminated. Once the replacement property has been acquired and the exchange is finalized, any remaining funds that were not used for reinvestment can be released to the investor. Those released funds will be taxable, but the transaction will remain valid for the portion that was properly exchanged.
Planning a Partial Exchange Effectively
A partial 1031 exchange—where an investor reinvests only part of the proceeds—requires careful planning. The investor should begin by consulting with a qualified intermediary and a financial or tax advisor to understand the potential impact of receiving cash or other non-like-kind property. The intermediary will ensure that the funds are held securely and disbursed properly according to the exchange agreement.
Investors should also consider how retaining some of the proceeds aligns with their long-term investment goals. While keeping cash may provide short-term liquidity or cover immediate expenses, it can also limit the overall tax-deferral benefits of the exchange. Every dollar that remains invested in a like-kind property continues to grow tax-deferred, providing more potential for future appreciation and reinvestment opportunities.
Frequently Asked Questions
Can I choose to take some cash out after closing on the replacement property?
Yes. Once the exchange is finalized, any unused funds can be released to you. These funds are taxable as boot, but the rest of the exchange remains valid.
Is there a limit to how much I can keep from the proceeds?
There is no specific limit, but the more you retain, the greater your taxable liability. To maximize deferral, reinvest as much as possible into the replacement property.
Should I consult a professional before structuring a partial exchange?
Absolutely. Because the tax and compliance rules are complex, consulting a qualified intermediary and tax advisor is essential to avoid errors and maximize the benefits of your 1031 exchange.
Contact 1031 Federal Exchange to Learn More About Ohio 1031 Exchanges
Speak with 1031 Federal Exchange today about Ohio 1031 exchanges. Call 513-488-1135 or contact us online to schedule a free consultation. We are located in Loveland, Ohio and serve clients nationwide.