For real estate investors, being able to access the equity that has accumulated in their portfolio can be very important. One of the most common methods for doing so is a cash-out refinance. For those who are about to conduct a 1031 exchange, or those who have just completed an exchange, the questions of whether and when they can “pull out” such equity from their properties can be very important.

Generally speaking, it is better to refinance a replacement property purchased in a 1031 exchange, rather than pull equity out of a relinquished property prior to selling it. The American Bar Association Section on Taxation has explained the reasoning for this distinction as follows:

“The key to the distinction between pre-and post-exchange refinancings is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for pre-exchange relinquished property refinancing upon transfer of the relinquished property.  A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth.”

Nevertheless, if one is determined to refinance their relinquished property before selling it, the following suggestions may help if the transaction later falls under scrutiny:

• The sale and the refinance should be completely separate transactions and should not occur concurrently. Based on prevailing authority, this issue is critical and applies to refinances on both relinquished and replacement properties.
• Refinance as long as possible prior to completing the sale. Ideally, the refinance would occur a minimum of 6 months before selling the relinquished property.
• Be able to show that the funds were required for a valid business purpose. For example, an exchanger might need the funds to repair their relinquished property prior to selling it. Whatever the purpose, it is crucial that it be well documented and that such documentation be saved.

With respect to replacement property, many authorities take the position that refinancing a replacement property at any time after its acquisition is acceptable. That being said, following the above suggestions, even on the refinance of a replacement property, is a more conservative approach.  In addition, some authorities recommend waiting until the purchase is complete before even initiating the refinance process on a replacement property.

As each situation is unique, exchangers should always seek the guidance of an attorney or tax advisor prior to initiating any refinance on a property that has been (or will be) part of an exchange.

If you or someone you know has questions about the 1031 exchange process, we at Peak 1031 Exchange are your qualified experts who are here to help. Contact us today at [email protected] or by calling us at 866-357-1031 to discuss the deferral of capital gains taxes with a 1031 exchange.