Accessing Equity Tax Free in a 1031 Exchange

How can you get at the equity of your exchange without paying tax on it?

First some basic rules:

1. You can not touch the money in between the sale of your Old Property and the purchase of your New.

2. Any of the exchange proceeds you touch as part of your exchange will be taxable to you, even if the amount you withdraw is less than your actual cash equity in the property.

3. If you refinance your Old Property within a year and a day of the sale of that property, the IRS could make a case that you touched the money.

For example, Fred and Sue have a contract to sell their purple duplex in a 1031 exchange, which is debt free. The closing is scheduled for next month. Could they finance the duplex today to get $70,000 of loan proceeds so they can pay down the mortgage on their personal residence?

The answer is that if they do, and this is discovered by the IRS during an audit, most likely the IRS will argue that the financing was done in an attempt to circumvent the rules preventing touching the exchange proceeds. This would toast Fred and Sue's exchange.

If Fred and Sue financed their duplex today, how long would they have to wait until they could sell the property and not worry about the IRS making this argument? The best answer is at least a year and a day. At a minimum they should finance it before they list it for sale, and even then they have a risk that the IRS would say it was taxable. Financing it while they are under contract to sell is definitely high risk.

So now you know that you cannot finance (or refinance) your Old Property right before you sell it; and you know you can't touch the money in between the sale of the Old Property and the New. The only thing left is to finance or refinance your New Property -- and yes, this is the correct answer; the secret to getting funds out of an exchange tax free.

While you cannot finance your Old Property, or touch the proceeds during the exchange, the IRS will let you finance (or refinance) your New Property immediately after you purchase it. How long after? One "nanosecond" is the IRS answer, provided that you complete your exchange first. One nanosecond means just that -- immediately after the purchase. You can literally walk away from the closing with a check in your hands.

So back to Fred and Sue -- their purple duplex is free and clear, they sell it for $100,000 and do a 1031 exchange. Their intermediary is now holding these proceeds. When Fred and Sue purchase their New Property, the intermediary will transfer the proceeds to the title or escrow officer for the closing. The settlement statement for the closing will show all of the funds being used for the purchase. During the closing Fred and Sue can sign loan documents borrowing $70,000 against the New Property. As soon as their purchase is completed, the lender closes the loan, and Fred and Sue can walk away from the closing with their check, and with the blessings of the IRS.

Technically, what happens in a situation like this is what we call a "touch down" -- like a plane practicing landings. Fred and Sue's exchange 'touches down' for a moment and they use all of their exchange funds to purchase the New Property. They then 'take off' again with the new loan and a check for $70,000. This 'touch down' must be clearly documented, and usually the intermediary must walk the lender step by step through the closing so that they understand what is happening and why. For this reason make sure that you are working with a really good intermediary if you intend to finance, or refinance, your New Property at the closing.