Debt Can Be Good With A 1031 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.

To keep in line with the 1031 rationale, all of the proceeds from the sale are supposed to pass to the qualified intermediary - this prevents you from receiving any cash benefit from the sale. But, suppose you want that new car or want to take the family on a vacation and don't have the cash to do it. So, you decide to refinance your property shortly before the 1031 exchange and use that equity for your desired luxury item. A smart move? Probably not, according to IRS v. Garcia.

In IRS vs. Garcia, it was decided that Garcia when refinancing his property in anticipation of the 1031 exchange, should have paid taxes on the money not used on the new property. Garcia tried to avoid the tax and ran afoul of the 1031 rationale and the IRS.

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.

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.

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. - 23204

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.