Financial Information

We all know that the 1031 Exchange is used for transferring equity from an old property to a replacement property. In effect, the old debt is being offset by the new debt on the replacement property. You can use pre-exchange refinancing or post-exchange refinancing. Pre-exchange financing will be discussed first.

In a 1031 exchange, all the proceeds from the sale are supposed to be passed on to the Qualified Intermediary. 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. There may be times, however, when you would like to use some of that money for other purposes. A smart move? Probably not, according to IRS v. Garcia.

Garcia was a taxpayer who decided to refinance his property in anticipation of the 1031 exchange.Garcia tried to avoid taxes and ran afoul of the 1031 rationale and the IRS.In order for you to avoid the Garcia issue, you may decide to refinance the replacement property. It can be acceptable to pay taxes or cash out the equity otherwise known as ‘boot’. Garcia tried to avoid the tax and ran afoul of the 1031 rationale, and the IRS.

Refinancing the replacement property is a way of avoiding the Garcia issue. This is a good way for you to take some of that equity out of the replacement property and buy more real estate. Not all taxpayers want to leave their equity in the replacement property - some want to take out that equity and buy more real estate. There is a question, however, on how long you have to wait before the refinancing after the 1031 Exchange is completed? 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 (after the tax exchange) from the lender to you. What we have is essentially a pool of money that you can access after the exchange.

There is debate on how long one must wait after the 1031 exchange to show the IRS, through the closing statement, that you have invested all of your equity into the replacement property. There are risks because there is no definitive IRS rule regarding how long you have to keep the equity in the replacement property. A more prudent approach would be to keep the money in the replacement property in order to avoid the Garcia trap. When this is the situation, 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.