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.

In a 1031 exchange, all the proceeds from the sale are supposed to be passed on to the Qualified Intermediary – this prevents you from receiving any cash benefit from the sale. There may be times, however, when you would like to use some of that money for other purposes. If you decide to refinance your property shortly before the 1031 exchange and use that equity for your desired luxury item, you may find yourself violating IRS rules. (IRS vs. Garcia)

We have tax case IRS versus Garcia which tells us that the refinance must be done well prior to the 1031 Exchange. Garcia tried to avoid taxes and ran afoul of the 1031 rationale and the IRS. He ran into problems because he refinanced just before the 1031 Exchange and tried to take proceeds without paying the taxes. Therefore, you can’t take out equity unless you pay taxes on it.

The other way of recovering funds via refinancing is the Post 1031 Exchange Finance on the replacement property. This is a good way for you to take some of that equity out of the replacement property 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.

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.

There are risks in the nanosecond interpretation since there is no definitive IRS rule regarding how long you have to keep the equity in the replacement property. In order to avoid the Garcia trap, or a negative ruling from the IRS, it is deemed prudent to 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.

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