An essential concept behind the process of a 1031 tax exchange is that a real estate investor must not draw any direct benefit from the funds gained as the result of the sale of his or her 1031 property; any cash removed from the sale is seen as ‘boot’, and as a result it is subject to capital gains taxes. As a result of this, refinancing in order to remove stored value from the replacement property enters into a very nebulous area in terms of acceptability under Section 1031.
In a case brought against a real estate investor by the name of Garcia, a tax court made it clear that all benefit received by a taxpayer the refinance of a piece of real estate in anticipation of selling it in a 1031 exchange will be deemed to be taxable boot. This court decision set a precedent for the manner in which these kinds of issues. Currently, a more common tactic is waiting until after the closing on the replacement property, and to refinance the piece of property at some point afterward. This strategy, however, brings up the question of how long it is appropriate to wait before refinance and removing value from a property.
The most conservative investors would tell you that you should wait a considerable period of time post-closing (maybe even two years), in order ensure that you are in compliance with the implicit meaning of Section 1031. The recent trend amongst the more liberal-minded contingency of property investors, however, is to assume that closing on a replacement represents a definitive end to the 1031 process, and so one need not worry about the substantiation of an exchange after this point. To a real estate investor who perceives the exchange process from this vantage point, it doesn’t matter the amount of time one waits before refinancing a 1031 replacement property, and many will choose to do so immediately after the closing has taken place.
If you are hoping for any definitive rule as to when it is safe to refinance a 1031 replacement property, you are doomed to disappointment, at least within the confines of this short article. The two perspectives that I have described in this article are merely opinions, and they represent extremes on a wide spectrum. Property investors vary a good deal when it comes to the manner in which they choose to approach these sorts of legally gray areas, and the most helpful advice that I can {give you is simply to speak with a qualified tax adviser or other legal expert in formulating your ultimate decision, and to work closely with him or her so that you can decide on the approach that will work best in light of your specific situation.