How to Address the Issue 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 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 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. 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. This usually leads to the question of how long into the future should one wait to refinance and take 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. This is to be sure you have complied with 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. They see no barriers to any attempt to the substantiation of the exchange once this time has passed. They fail to see the purpose of waiting for any longer in refinancing the replacement property. They normally proceed to do this, once the closing is complete.
For those who wish to be given a clear guideline on the exact time to proceed with the refinancing of the replacement property, it is not an easy thing to give forth. The difference between the opinions of the conservative investors and their more liberal counterparts cover a wide area of thinking. There are more perspectives in between these extremes. The equity issue in 1031 exchanges is normally a gray area at best. Real estate investors will interpret it in so many different ways. It would be best to consult the services of a qualified tax adviser, or a similar legal expert, before making your final decision. 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.