Undergoing a 1031 Exchange is a strategy for investors who want to defer their capital gains taxes. However, there are those who may consider pulling out equity from the 1031 Exchange funds for various reasons. As such, it’s common enough to question whether or not you can take out equity from this transaction. The answer is nuanced, but this practice is indeed possible. This article examines the regulations governing this action and provides guidance on how to remain compliant. Keep reading to learn more.
What Is 1031 Exchange Equity?
In the context of real estate, equity refers to the difference between the property’s value and the remainder of the mortgage loan. A traditional property allows a homeowner to access equity through a sale. However, things get more complicated in a 1031 Exchange. Since the like-kind exchange involves a swap, not a sale, you’re compelled to reinvest all the proceeds from the relinquished property to maintain your full tax-deferred status.
If you attempt to pull cash from the exchange of your relinquished property, it can result in a taxable “boot.” This is any non-like-kind property or cash you received during the exchange, and boot is taxed as capital gains. As such, it’s important to understand the structure and processes involved in a 1031 Exchange to determine when you can pull out equity.
Can You Take Out Equity From a 1031 Exchange?
Technically, yes. You’re free to pull out cash from the exchange, but like we said above, this will be categorized as boot. The transaction would only be partially tax-deferred. Of course, many investors would prefer full tax deferrals, but it’s not possible to take out equity without incurring tax obligations.
Strategies to Access Equity While Still Complying With IRS Rules
There are two ways to access the equity from a 1031 Exchange without triggering a taxable event.
Refinancing Before the Exchange
This strategy takes place before you sell the relinquished property. You take out a loan and extract cash before beginning the 1031 Exchange process, allowing you to access equity without receiving boot. This strategy has some risks. For example, if you refinance too close to the start of the exchange, the IRS may see the swap as simply a step transaction to avoid taxes, leading to scrutiny. There is no formal specification for how far in advance a pre-exchange refinance must occur, but practitioners generally recommend a substantial time gap (commonly 6–12 months). Additionally, The taxpayer must be able to demonstrate a legitimate business or investment purpose for the refinance, independent of the exchange.
Refinancing After the Exchange
The other strategy is to refinance after completing the 1031 Exchange. This method reduces the risk of IRS scrutiny and allows investors to pull cash out tax-free. The refinance should not be prearranged as part of the exchange plan. If there is evidence of premeditated financing, the IRS may again apply the step transaction doctrine. Additionally, lenders may require a waiting period (e.g., 6–12 months) before approving a refinance.
Differences Between Direct vs. Indirect 1031 Investments
The ownership structure of the real estate property affects how you can pull equity from a 1031 Exchange. For example, those who have direct ownership can enjoy more flexibility in refinancing. It’s much easier to use the strategies we shared above.
However, those who indirectly own property may find it more difficult. For example, investors in a Delaware Statutory Trust (DST) may find that refinancing is not possible at all since they don’t hold a direct title to the property. As such, investors looking for liquidity should consider alternative structures.
Wrapping Up: Accessing 1031 Exchange Equity
While it is possible to access the equity from a 1031 Exchange, you must be aware that the funds will be considered boot and are taxable. Employing strategies like refinancing the property before or after the exchange can help, but proper planning is essential to minimize IRS scrutiny. Contact Realized 1031 today if you wish to learn more about these approaches.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Cited Sources:
https://www.investopedia.com/terms/h/home_equity.asp
https://nstp.org/memberarea/federaltaxalert/2023/what-is-boot-in-a-1031-exchange
