Transform Your Debt With A 1031 Tax Exchange

By Kevin Y. Delno

Although 1031 Exchanges are primarily used to shift our equity from one property to another, there are ways of recovering some of that equity for use as leisure or further investment purposes. There are two ways to recover money from your property - before or after the 1031 Exchange is completed.

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.

In order for you to avoid the Garcia issue, you may decide to refinance the replacement property. In post-exchange financing, taxpayers may not want to leave all of their equity in the replacement property - some want to take out that equity and buy more real estate. However, how long should you wait after completing the 1031 exchange before you take out the equity in the replacement property?

The nanosecond refinance is waiting just long enough after the 1031 to show the IRS, through the closing statement, that you've re-invested all of your equity into the replacement property. In a separate transaction, a new settlement statement is used to show that the replacement property was encumbered with new debt via a loan or mortgage, then there is a cash payment from the lender to you. Thus, there is a pool of money 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. - 23217

About the Author:

U.S. investors 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 like an interest free loan from Uncle Sam.