Exchange Your Debt With A 1031 Tax Exchange

By Kevin Y. Delno

We all know that the 1031 Exchange is used for transferring equity from an old property to a replacement property. What is not customarily known is that you can use some of the equity from your property through proper refinancing. You can use pre-exchange refinancing or post-exchange refinancing.

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.

In IRS vs. Garcia, it was decided that Garcia when refinancing his property in anticipation of the 1031 exchange, should have paid taxes on the money not used on the new property. 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.

The legality of the nanosecond exchange is debatable. There are risks because there is no definitive IRS rule regarding how long you are 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. 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 finance. - 23159

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U.S. investors can save big money by using a 1031 exchange to defer all of their capital gains tax on the sale of investment property. A 1031 tax exchange is like an interest free loan from the IRS.