Taxpayers often wish to pull money out of their properties in an effort to take advantage of the increased equity. One way to do this is by refinancing the property with a third-party lender (a §1031 exchange), which frees up what would otherwise be captive equity. However, this can become complicated. It is important to remember that any cash received or debt relieved in the course of a §1031 exchange is considered “boot” and is subject to taxation.
Before the exchange
Some taxpayers may wish to refinance their existing or soon-to-be- relinquished property in a §1031 exchange.
Where most of these taxpayers run into trouble is when they opt to refinance prior to their exchange. A key objective of the IRS is to prevent taxpayers from taking cash out of their exchange simply to avoid paying taxes. Thus, the service has unofficial “in anticipation of exchange” guidelines. These guidelines trace their origins to installment sale provisions in the Internal Revenue Code, and related cases where debt placed on property “in contemplation of disposition of the property” triggered a taxable event for the taxpayer.
In Long v. Commissioner, 77 TC 1045 (1981), the Court held that based on the totality of the circumstances, if the refinance was an integrated part of a transaction that included an exchange, the taxpayer would be treated as having “cashed out” to the extent of the refinancing and would be taxed on that amount. This reasoning continued in Private Letter Ruling 8434015, where the Service asserted that cash proceeds from a refinance immediately preceding the disposition of property in an exchange constituted taxable boot.
However, the Tax Court repeatedly takes a narrower view of what should be taxed as boot. In Fredericks v. Commissioner, TC Memo 1994-27, the Court held that even though the taxpayer refinanced his relinquished property one week after entering into a sales agreement, the refinanced proceeds were not part of the exchange. In this case, there was ample evidence that the refi had economic significance independent of the exchange. Specifically, the taxpayer had a loan in place that was reaching maturity and had been working on the refi for some time before entering into the sales agreement. Without the exchange, the refi would have been essential to the ongoing ownership of the property.
Other scenarios have also resulted in ruling in favor of the taxpayer, including the opportunity to take advantage of lower interest rates, and the ability to acquire additional replacement properties. These scenarios are generally in keeping with the intent of §1031—ongoing investment.
After the exchange
Sometimes taxpayers opt to refinance their replacement property upon completion of their exchanges. Generally speaking, this is a less risky course of action. By definition, funds received after the exchange is complete are not taxable because they bring an obligation to repay the funds. In this case, the receipt of the loan proceeds does not result in a taxable event because it does not cause a net increase in the taxpayer’s wealth. When the taxpayer refinances prior to the exchange, the liability is relieved upon the transfer of the property. This scenario bears a strong resemblance to “cashing out,” which is the antithesis of the §1031 exchange. However, when the taxpayer refinances after the exchange is completed, the liability remains in full force.
Unfortunately, there is virtually no published authority in favor of or against the practice of refinancing after the exchange. As always, taxpayers are cautioned to have their tax and legal advisors review the structure of the entire transaction. Such a review is crucial to the success of §1031 exchanges. Failure to do so may result in unwanted tax consequences.
Equity in a taxpayer’s property can be fully utilized to his/her advantage. While a pre-exchange refinancing can be successful, it must be structured with the utmost care. However, as noted above, a post-exchange refinancing is far less risky.
IRC Section 1031 allows taxpayers to defer the gain on the disposition of business or investment real estate, if that real estate is replaced with other business or investment real estate, within specific timeframes. Consult your tax or legal advisor for additional information on the requirements and limitations of such exchanges. Wilmington Trust 1031 Exchange LLC is a wholly owned subsidiary of Wilmington Trust, N.A. *Wilmington Trust 1031 Exchange LLC does not provide tax or legal advice to clients. Please consult professionals in those areas before making any decisions.