Equity in a 1031 Exchange
The main concept surrounding the process of a 1031 tax exchange is that an investor cannot draw any cash benefit from the proceeds of the sale of the relinquished 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 not easy to define exactly which state is acceptable 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. Through such cases, there emerged a general rule of how similar cases were to be viewed in the future. This is why we see in most instances where the replacement property is yet to be closed, nothing happens until this step takes place, then others can follow, such as the refinancing of the said property. 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. Another trend coming up is one from the more liberal real estate investors who understand that as soon as the buying of the replacement property has been finalized, the 1031 process is over and done with, and its requirements fully met. They see no barriers to any attempt to the substantiation of the exchange once this time has passed. They do not see the point in waiting for long periods to refinance 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 two extremes in terms of thinking by the liberal and conservative real estate investors span a wide range of thought and perspective. There are other variations in terms of views in between these opposites. The equity issue in 1031 exchanges is normally a gray area at best. Real estate investors are left to treat it as they see fit. It is therefore advisable to consult a tax adviser specialized n such matters when you wish to decide on 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.