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Understanding the Concept of Equity in a 1031 Exchange

In a 1031 tax exchange situation, it is clearly understood that an investor will not receive any cash benefit from the proceeds of the sale of the relinquished property, and this forms the basis of the whole idea of 1031 exchanges. In case there is any benefit, it will be subjected to capital gains taxing. This interpretation of the law has made the practice of refinancing for the sole purpose of removing equity from the 1031 replacement property a very hard one to fully understand. It is not easy to define exactly which state is acceptable under Section 1031.

In the past, any court case in which it was found that benefits had been collected by a taxpayer from the refinancing of property before being sold in a 1031 exchange were to be assumed to be profits. This set a precedent on how such cases would be handled forthwith. 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.

Some of the most conservative real estate investors will tell you to wait for a long period, two years even, in certain situations. They do this in order to be sure they have met the requirements of Section 1031. Another group of less conservative real estate investors believes that once the purchase of the replacement property has been done, the 1031 process is complete. They see no barriers to any attempt to the substantiation of the exchange once this time has passed. They fail to see the purpose of waiting for any longer in refinancing the replacement property. Expect them to do so once the closing is done.

For those who wish to be given a clear guideline on the exact time to proceed with the refinancing of the replacement property, it is not an easy thing to give forth. 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 many other perspectives and opinions covering the wide space in between these two. 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 would be best to consult the services of a qualified tax adviser, or a similar legal expert, before making your final decision. For the sake of your compliance, you will have to work closely with them, so that you make the best decision with regards to your specific case.

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