Can I Refinance a 1031 Exchange Property?
**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**
You do have the option of refinancing before or after your 1031 exchange. In this article, we’ll explain why post-exchanges are widely preferred by tax advisors. Yet if you see real benefits, we’ll also cover what it takes for pre-exchange refinancing to succeed, as well.
Refinances pre-exchange are far riskier. If you take cash out pre-exchange, it’s important to have an independent business purpose. Reasons need to be independent of any anticipated 1031 exchange and intent to simply avoid taxation.
This is critical because on audit the IRS may tax cash withdrawal as boot or worse revoke the exchange altogether as abusive. Defining issues all revolve around your intent for refinancing. Relevant facts and circumstances rule the day. That puts a premium on advanced planning with supporting professional guidance by a CPA/tax advisor working together with one of your local 1031 exchange companies. It gets complicated and time-consuming quickly.
1031 Exchange Refinancing Rules
Generally while offering little certainty, the IRS is clear about one pre-exchange issue:
Taxpayers cannot receive funds from relinquished property sales until replacements are purchased.
Given that, will cash taken from refinancing old property pre-exchange constitute money received? Doesn’t seem possible since there’s yet to be an exchange.
But here the IRS may apply its step-transaction doctrine along with a substance-over-form principle. As such, if a step within a multi-step transaction is taken solely to alter a tax outcome, then it may be ruled a sham. Arguing substance trumps form, the IRS may treat cash out in this instance as taxable boot (discussed in our articles on how boot is taxed in 1031 exchange and partial 1031 tax-deferred exchanges).
After all, that’s what would occur in a step transaction when cash is withdrawn in a 1031 exchange. Cashing out in advance then could be perceived as a ruse in the absence of evidence to the contrary. Worse, should the IRS contend abuse exists, the entire exchange could be revoked making the whole exchange a taxable event.
Conversely, post-exchange refinancing raises no such red flags with the IRS. That’s likely due to the absence of any taxpayer gain. Here the borrowed money (replacement’s outstanding debt) has to be repaid and therefore constitutes no net increase in wealth.
The following two sections will delve into the particulars of post- versus pre-exchange refinancing.
Can I Refinance After a 1031 Exchange?
Post-1031 Refinancing Review
Tax advisors generally agree this should not result in any significant tax issues. Again, the logic is that anyone refinancing after a 1031 exchange retains the debt obligation on the replacement property. It serves as an offset to any receipt of cash. This is unlike relinquished property where you would have the loan debt repaid on closing while retaining cash from refinancing.
This is likely the primary reason why the IRS looks more favorably upon post- versus pre-exchange refinancing. There are no net wealth gains when refinancing post-exchange.
This is supported by an American Bar Association Section of Taxation’s Comments Concerning Open Issues in Section 1031 Like-Kind Exchanges. It reads in part in Answer 2b- Post-Exchange Refinances:
Post-exchange refinancing should be of less concern from a tax perspective than pre-exchange refinancing. Here the integration of the refinancing with the acquisition of replacement property should not matter. Even where a new loan is obtained at the time or immediately following a taxpayer’s acquisition of replacement property in an exchange, receipt of cash by the taxpayer should not be treated as boot.
Coming from the ABA, this is reassuring in the absence of much clarity from the IRS. Nonetheless, here are some safeguards to consider when refinancing. You should:
- keep refinancing transactions apart from all other transactions to avoid interdependence,
- assemble and maintain a paper trail to support independent transactions, and
- always be able to demonstrate refinancing had an independent business motivation.
Post-1031 Refinancing Summary
There’s nothing obvious stopping you from going this route. This exchange allows you to preserve your equity through full tax deferral. Yet refinancing post-exchange may offer some incentives.
Uses of post-exchange cash loans are unrestricted. With those immediate 1031 exchange savings, you as an investor may diversify investments or reinvest in other assets of your choice.
Can I Refinance Before a 1031 Exchange?
Pre-1031 Refinancing Review
Maybe you can and still avoid taxable boot on any cash withdrawals. But much depends on when and under what circumstance you refinance. If you’ve planned well in advance or just happen to have favorable circumstances, pre-exchange refinancing may work out favorably.
If your refinancing is at least a year ahead of the exchange, some experts say that’s enough of a safety net to proceed unchallenged. Not so under a year with no apparent business purpose other than just to avoid taxes. Then at the exchange, your plan to receive full tax deferral despite receiving untaxed cash could fail.
Nice try the IRS may contend, but just bridging the start date doesn’t interrupt a step transaction. It should be followed to its logical conclusion. So, the IRS might argue that cash taken out immediately preceding an exchange is merely one step in a multiple step process.
The outcome will thus be treated the same as cashing out during an exchange. You’re not reinvesting all of the relinquished property’s equity. That’s a violation of the like kind exchange rule.
The contention is that it’s substance overtrumping form. You’re performing a step (withdrawing cash) which is one step of multiple steps. Again, with no substantive evidence of another business purpose for the refinancing, tax avoidance becomes the presumed motivation. Essentially an intent test applies with the burden of proof on you.
What might constitute convincing business purposes other than tax avoidance? Case law and other examples that follow reflect mixed results. They show how establishing independence between transactions could overcome refinancing just prior to a 1031 exchange. The key is conducting independent actions to disrupt the step argument. You can have the substance-over-form argument work for you.
In Fredericks v. Commissioner, Tax Court Memo 1994-27, relinquished property was refinanced less than a month prior to the 1031 exchange. The US Tax Court was asked to decide whether the IRS could force the recognition of taxable gain on the exchange.
The IRS attempted to apply the step transaction doctrine to argue that the refinancing proceeds were taxable boot. The Fredericks argued that another business purpose was evident. They proved that several attempts were made to refinance the property over a two-year period.
The Court agreed and ruled the refinance had an independent purpose. As such the transaction was not made for the sole purpose of tax avoidance. No taxable boot was created.
In Phillip Garcia v. Commissioner, 80 Tax Court 491 (1983), aff’d. 1984 -2 CB 1, the seller of the replacement property increased its debt just before the exchange. The stated intention was to equalize liabilities with the relinquished property.
The IRS contended that the mortgage increase was a step transaction that should result in boot being received by the Exchanger. They argued pre-exchange debt was increased just to avoid creating taxable boot on exchange.
However, the Court rejected the IRS’s position, finding that the replacement property mortgage increase had independent economic substance.
In Private Letter Ruling 8434015 the IRS ruled that a proposed refinancing’s proceeds received just before the exchange date would create taxable boot. In this case, not having established independence between the proposed refinancing and the exchange was the critical factor.
Pre-1031 Refinancing Summary
Despite examples of pre-exchange refinancing success cited here, the consensus among most experts is replacement property post-exchange refinancing is preferable. The IRS, it appears, has largely acquiesced on refinanced replacements post-exchange.
Favoring post-exchanges is especially true if it’s late in the game for refinancing prior to exchange start dates. Or should little persuasive evidence exist arguing against tax avoidance.
Timing is an important factor. Refinancing one year or more before relinquished property sales making an IRS challenge doubtful. Short of that due diligence is required if you’re planning to take out cash. Then refinancing demands a strong non-tax avoidance business case to preclude any IRS step transaction imposition.
Final arbiters on the linchpin question of intent are the courts. Again, with the burden of proof on you, that’s seldom where you want to be. It’s clear that post-exchange refinance affords far less risk of an IRS challenge. Yes, with the right set of facts and circumstances, pre-exchange refinancing isn’t precluded. Just be sure the benefits outweigh the risks.
You should carefully consider the following issues when assessing risk.
- Refinancing loans should not appear to be solely for the purpose for cashing out.
- Refinancing should be separated from the exchange sale to show independent business purpose.
- Exchangers should complete refinancing prior to listing the relinquished properties for sale.
- Refinancing loans and exchange sales should be documented as separate transactions to avoid any appearance of interdependence.
It’s apparent that the IRS has largely acquiesced on post-exchange refinancing. It’s also preferred by most experts. This is especially true when:
it’s late in the game for refinancing pre-exchange with the exchange starting soon or
you possess little convincing evidence arguing against tax avoidance.
To keep all options open in any event, I recommend you plan ahead as much as possible. Set in place those facts and circumstances showing independent business purpose for refinancing at any point. Unless you are already well-versed on what that entails, I also recommend you reach out for professional advice.
How to Comply with IRS Rules
Unless you are doing a simultaneous 1031 exchange, you must use a Qualified Intermediary. Professional QIs are experts in all aspects of 1031 exchanges.
A reputable 1031 exchange company with tax attorneys on their team will consult you and your tax advisor/CPA. They will review your situation and advise on whether your refinancing plans satisfy the IRS requirements or need adjustments to perfectly comply with the rules.
PropertyCashin is an all-in-one platform for commercial real estate investors that maintains relationships with top-rated 1031 exchange firms in all locations of the USA. To get connected with the best professionals and have your exchange processed safely and effectively, fill out the form below.