Refinancing – timing is everything

Often, and Investor will want to take some equity out of a Replacement Property to be utilized for other investments or for personal use.  Section 1031 provides that cash taken by an Investor as part of the exchange and not reinvested into the Replacement Property will be treated as “boot” and subject to tax.  Because of this rule, many real estate investors never consider an exchange because they mistakenly believe their equity must always remain tied up in real estate.  However, it is possible for an Investor to obtain cash through the use of refinancing and use that cash tax free for whatever the investor chooses, whether that is buying more real estate, investing in the stock market or utilizing the cash for personal use.

PRE EXCHANGE REFINANCE OF RELINQUISHED PROPERTY

An Investor should not refinance the Relinquished Property shortly before a sale that is structured as 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 additional 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).  Therefore, there is a strong possibility that proceeds received by the Investor from a refinance of the Relinquished Property completed shortly before the exchange will be treated as cash boot and subject to tax.

POST EXCHANGE REFINANCING

It is much safer for an Investor to refinance the Replacement Property after completing the exchange transaction in order to receive cash.  Any refinancing should be completed as a separate transaction and not reflected on the closing statement for the Replacement Property.  Proceeds received from a post acquisition refinance of the Replacement Property will not be subject to tax.

As with all exchange issues, we recommend that every Investor consult with their personal tax advisor to review their specific situation with respect to structuring a cash out refinance.