Debt Can Be Good With A 1031 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.

In a 1031 exchange, all the proceeds from the sale are supposed to be passed on 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 that money for other purposes. If you decide to refinance your property shortly before the 1031 exchange and use that equity for your desired luxury item, you may find yourself violating IRS rules. (IRS vs. Garcia)

Garcia was a taxpayer who decided to refinance his property in anticipation of the 1031 exchange. The IRS successfully argued that when Garcia took out money before the 1031, it was akin to telling the settlement agent to pay him some of the sale proceeds at closing. In short, you cannot take out your equity just before the 1031 exchange. Cashing out equity, called "boot," is acceptable if you pay taxes on it. Garcia tried to avoid the tax and ran afoul of the 1031 rationale, and the IRS.

The other way of recovering funds via refinancing is the Post 1031 Exchange Finance on the replacement property. This is a good way for you to take some of that equity out of the replacement property and buy more real estate. There is a question, however, on how long you have to wait before the refinancing after the 1031 Exchange is completed.

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. - 23208

About the Author:

United States investors can save a lot of money by using 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.