Transform 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.

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.

Some will tell you that the time required for the finance is but a nanosecond. The nanosecond refinance is waiting just long enough after the 1031 Exchange to show the IRS through the closing statement that you have reinvested all of your equity into the replacement property. In a separate transaction, a new statement is used to show that the replacement property is encumbered with new debt via a loan or mortgage. Then there is cash payment from the lender to you. What we have is essentially a pool of money that you can access after the exchange.

Whether the nanosecond exchange is legal is debatable. There are risks because there is no definitive IRS rule regarding how long you have to keep the equity in the replacement property. The conservative school of thought says to keep the money in the replacement property in order to avoid the Garcia trap. In this case, 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. - 23200

About the Author:

Investors in the U.S. can save big money by utilizing 1031 tax exchanges to defer all of their capital gains tax on the sale of investment property. 1031 exchanges are like an interest free loan from Uncle Sam.