Understanding the Concept of Equity in a 1031 Exchange
It is the foundation of the idea of a 1031 tax exchange, where an investor knows he/she cannot draw any cash benefit from the returns of the sale of the primary property. Should there be any cash benefit, it will be treatable to capital gains taxes. This general rule has made the practice of refinancing with the purpose of removing equity from the 1031 exchange replacement property a very difficult one to handle. It is not easy to define exactly which state is acceptable under Section 1031.
In the past, any court case in which it was found that benefits had been collected by a taxpayer from the refinancing of property before being sold in a 1031 exchange were to be assumed to be profits. Through such cases, there emerged a general rule of how similar cases were to be viewed in the future. It is now a common practice to wait for the replacement property o be closed, before the process of refinancing it can start. This has also presented another concern, where people wonder how long they have to wait going forth, before refinancing and taking equity from the replacement property.
The most reserved of investors would advise you to wait for a particularly lengthy period after closing, as long as two years in some cases. They do this in order to be sure they have met the requirements of Section 1031. Another trend coming up is one from the more liberal real estate investors who understand that as soon as the buying of the replacement property has been finalized, the 1031 process is over and done with, and its requirements fully met. 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. Expect them to do so once the closing is done.
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 more perspectives in between these extremes. The matter of equity in a 1031 exchange remains an ambiguous one at best. Real estate investors are left to treat it as they see fit. You will have better chances when you ask a qualified tax expert for their guidance in such a case. For the sake of your compliance, you will have to work closely with them, so that you make the best decision with regards to your specific case.