A common question that we are asked when working with investors contemplating a 1031 tax deferred exchange is: Can I refinance the property and pull out cash before or after I complete my exchange? Unfortunately there is no clear cut answer to this question, but hopefully the information in this article will provide you with some clarity.
In order to completely defer all tax in a 1031 exchange, you need to acquire property equal to or greater in value than the property you have sold, and you need to reinvest all of the net cash you receive from the sale of the relinquished property. Because of the rule which requires you to reinvest all of the equity, when you refinance right before or after a 1031 exchange, the IRS may question whether you refinanced to avoid complying with the 1031 rules or whether you did it for a legitimate business purpose.
Under the step transaction doctrine, the IRS may argue that what you did in several steps (close your exchange as step one and refinance your property as step two) was really all a part of one transaction. Under that theory, the IRS could take the position that you may be considered to have taken cash boot in your exchange. If that happens, an exchange that you thought was completely tax-deferred would be at least partially taxable. It is important to consult with your tax advisor when deciding whether and how to refinance properties that are involved in an exchange.
Here are a few suggestions that you may want to consider:
- The loan should have a clear business purpose which should be well documented in your files. For example, the maturity date of the loan may be approaching and you may want to set up a refinance prior to the exchange in case the exchange does not go through. Other potential business purposes may be to get a lower interest rate or to buy property that is not a part of the exchange.
- If you schedule your refinance and exchange so that there is as much time in between them as possible, it should make it less likely that you are audited concerning this issue. It should also strengthen your argument that the refinance was not set up to avoid the 1031 exchange rules. If you intend to refinance your relinquished property, you may want to refinance it before you list it for sale.
- Some tax advisors believe that it is better to refinance the replacement property after an exchange rather than to refinance the relinquished property before an exchange.
In any event, it is important to consider the risks and discuss your plans with your tax advisor.
from the First American Exchange Company October Newsletter “The Exchange Update”