Understanding the Concept of Equity in a 1031 Exchange
The main concept surrounding the process of a 1031 tax exchange is that an investor cannot draw any cash benefit from the proceeds of the sale of the relinquished property. If for some reason there is some benefit realized, it shall be loaded with capital gains taxes. This logic makes the practice of refinancing with the intention of removing equity from the 1031 replacement property a very challenging one. It is not easy to define exactly which state is acceptable under Section 1031.
It has been established in court cases before that any benefits gained by a taxpayer from the refinancing of a property before selling it in a 1031 exchange is to be taken as a profit. Through such cases, there emerged a general rule of how similar cases were to be viewed in the future. This is why we see in most instances where the replacement property is yet to be closed, nothing happens until this step takes place, then others can follow, such as the refinancing of the said property. 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.
Some of the most conservative real estate investors will tell you to wait for a long period, two years even, in certain situations. They do this in order to be sure they have met the requirements of Section 1031. There is an emerging thought among those less conservative real estate investors where they believe that as soon as the purchase of the replacement property is completed, the 1031 process is done. They see no barriers to any attempt to the substantiation of the exchange once this time has passed. Such investors don’t see the relevance of waiting any longer in refinancing the replacement property. They will do so immediately after the closing.
When an investor new to the processes of the 1031 tax exchange system wishes to know what makes a good waiting period that complies with all the regulations, they usually find it difficult to obtain such information. 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. It presents a challenge for real estate investors in trying to put it in context. 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.