Exchange Your Debt With A 1031 Tax Exchange

By Kevin Y. Delno

We all know that the 1031 Exchange is used for transferring equity from an old property to a replacement property. What is not customarily known is that you can use some of the equity from your property through proper refinancing. You can use pre-exchange refinancing or post-exchange refinancing.

1031 rationale requires all of the proceeds from the sale to pass to the Qualified Intermediary. This prevents you from receiving any cash benefit from the sale. There may be times, however, when you would like to use some of your equity for your own entertainment or investments. If you decide to refinance your property shortly before the 1031 exchange and use that equity for your own entertainment, you may run afoul of the IRS.

We have tax case IRS versus Garcia which tells us that the refinance must be done well prior to the 1031 Exchange. Garcia tried to avoid taxes and ran afoul of the 1031 rationale and the IRS. He ran into problems because he refinanced just before the 1031 Exchange and tried to take proceeds without paying the taxes. Therefore, you can't take out equity unless you pay taxes on it.

Now, you want to avoid the Garcia issue so you decide to refinance the replacement property. This is where post-exchange financing comes into play. Not all taxpayers want to leave their equity in the replacement property - some want to take out that equity and buy more real estate. But, how long should you wait after completing the 1031 exchange before you take out the equity in the replacement property? Some say wait a nanosecond.

There is debate on how long one must wait after the 1031 exchange to show the IRS, through the closing statement, that you have invested all of your equity into the replacement property. Some say wait a nanosecond to establish a separate transaction and a new settlement statement to show that the replacement property was encumbered with new debt via a loan or a mortgage. Once this is established, there is a cash payment from the lender to you. Essentially, you have tapped into a pool of money made available through the 1031 exchange.

There are risks in the nanosecond interpretation since there is no definitive IRS rule regarding how long you have to keep the equity in the replacement property. In order to avoid the Garcia trap, or a negative ruling from the IRS, it is deemed prudent to keep the equity in the replacement property until the following tax year, or until two years have passed from the 1031 exchange to the ultimate refinance. - 23199

About the Author:

Investors in the U.S. can save a lot of money by utilizing a 1031 exchange to defer all of their capital gains tax on the sale of investment property. A 1031 tax exchange is similar to an interest free loan from Uncle Sam.