WHAT ABOUT REFINANCING BEFORE OR AFTER AN EXCHANGE?
The primary objective of most Section 1031 exchanges is to move an investment from one property to another without incurring a tax liability. In other words, take your money out of this property and put it into another investment property and pay no capital gain tax. By following the rules and regulations of Section 1031 properly, an investor can accomplish that without having a capital gain tax bill.
However, many real estate investors never consider any consequences about effecting a 1031 exchange by refinancing their investment properties. The question is should I refinance my investment property before I start an exchange or after completing my exchange? When effecting a 1031 exchange, you must take great care to prevent taking a “cash boot” hit if audited by the IRS.
Occasionally someone we work with will ask a question like this: “How about if I refinance my property and pull cash out, then exchange into another property? Borrowed cash is tax-free, right?” The answer is yes, most of the time. However, if an investor refinances close to the date of a sale and then proceeds into an exchange, the IRS may reclassify the refinance proceeds as boot taken out of the exchange (and therefore demand that tax be paid) unless there was some fairly clear-cut business reason for the refinance outside of simply wanting tax-free cash.
THE TIMING IS IMPORTANT:
A real estate investor should not refinance the relinquished property and shortly thereafter perform a tax deferred exchange, unless it can be established that the debt incurred prior to the exchange had “independent economic substance.” If the Exchanger cannot support they had a valid business reason incurring addition debt prior to the sale, the IRS could easily characterize this as a “step transaction” (where they determine the steps leading up to the exchange show the investor’s original intent was merely to obtain the cash in an attempt to avoid the reinvestment rules of IRC §1031.) For example, in Private Letter Ruling 8434015, the IRS ruled that cash proceeds refinanced immediately prior to closing an exchange constituted taxable cash boot.
When contemplating a refinance after the purchase of the replacement property, care must be taken so that no commitments for a refinance are obtained prior to that closing. After the closing takes place, a refinance of the replacement property should be “untouchable”; if an independent business purpose for the refinance exists, so much the better. It’s safe to say that the more time that passes between the refinance and the sale (in the case of a relinquished property) or the purchase and a refinance (in the case of a replacement property), the better, although there appears to be no minimum amount of time required for either.
As always, it is critical to discuss matters such as this with one’s tax advisor for specific advice for your circumstances and plans. Please feel free to ask us any questions on this topic as well as any other exchange-related topics.
Wai-Yew Lam, President
TREC Certified Instructor