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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. 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 difficult to fully understand to say for sure what condition is appropriate 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. Such scenarios presented the basis of how similar cases would be treated in the future. Nowadays, what people do is wait for the replacement property to be closed, then refinance it at some future time. 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. This is to be sure you have complied with 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 do not see the reason to worry about the substantiation of the exchange once this period has elapsed. They fail to see the purpose of waiting for 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 difference between the views held by the conservative investor and those who are more liberally inclined speak of a wide disparity in terms of what is applicable. 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. 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. 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.

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