Equity in a 1031 Exchange
In a 1031 tax exchange situation, it is clearly understood that an investor will not receive any cash benefit from the proceeds of the sale of the relinquished property, and this forms the basis of the whole idea of 1031 exchanges. If for some reason there is some benefit realized, it shall be loaded with capital gains taxes. This interpretation of the law has made the practice of refinancing for the sole purpose of removing equity from the 1031 replacement property a very hard one to fully understand. It has proven a hard task to state clearly which state is acceptable under Section 1031.
It has been ruled in previous cases that all the benefits that were gotten by a taxpayer form the refinancing of a property prior to selling it in a 1031 exchange were to be treated as profits. This set a precedent on how such cases would be handled forthwith. It is now a common practice to wait for the replacement property o be closed, before the process of refinancing it can start. What has emerged as a consequence is the concern of how long into the future does someone need to wait to refinance and take equity from the replacement property.
If you ask a cautious real estate investor, he/she will advise you to wait, and not for a short while, sometimes not less than two years. Such a long period, according to them, is to confirm that all the legal requirements of Section 1031 have been met. Another group of less conservative real estate investors believes that once the purchase of the replacement property has been done, the 1031 process is complete. The see no restrictions as to why they should not substantiate the exchange once this time is over. Such investors don’t see the relevance of waiting any longer in refinancing the replacement property. They will do so immediately after the closing.
In case you were looking for a definite guide as to when to proceed with the refinancing of the replacement property, it will be difficult to obtain one. The two extremes in terms of thinking by the liberal and conservative real estate investors span a wide range of thought and perspective. There are other variations in terms of views in between these opposites. The matter of equity in a 1031 exchange remains an ambiguous one at best. Real estate investors will interpret it in so many different ways. You will have better chances when you ask a qualified tax expert for their guidance in such a case. You will need to work closely with them to come up with the best approach that will suit the specific situation you find yourself in.