The basic premise behind a 1031 exchange is that that you, the taxpayer, are shifting all of your equity from one property to the next. In effect, the old debt is being offset by the new debt on the replacement property. However, there are two ways to usurp this premise and cash out some of your equity: pre-exchange refinancing, and post-exchange refinancing. Pre-exchange financing will be discussed first.
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.
Garcia was a taxpayer who decided to refinance his property in anticipation of the 1031 exchange. The IRS successfully argued that when Garcia took out money before the 1031, it was akin to telling the settlement agent to pay him some of the sale proceeds at closing. In short, you cannot take out your equity just before the 1031 exchange. Cashing out equity, called “boot,” is acceptable if you pay taxes on it. 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.
The nanosecond refinance is waiting just long enough after the 1031 to show the IRS, through the closing statement, that you’ve re-invested all of your equity into the replacement property. In a separate transaction, a new settlement statement is used to show that the replacement property was encumbered with new debt via a loan or mortgage, then there is a cash payment from the lender to you. Thus, there is a pool of money you can access after the exchange.
Whether the nanosecond exchange is legal is debatable. There are risks because there is no definitive IRS rule regarding how long you have to keep the equity in the replacement property. The conservative school of thought says to keep the money in the replacement property in order to avoid the Garcia trap. In this case, 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.