Many people have questions about refinancing their replacement property after their exchange is over. Here we will answer some FAQs about refinancing after a 1031 exchange and offer some tips and best practices.
Refinancing after a 1031 Exchange
First off, refinancing one’s old relinquished property in anticipation of an exchange should be differentiated from post-exchange refinancing, done in a separate transaction after the exchange is completed. I think that the stronger more defensible position is for a post-exchange refinance (done in a separate transaction after the last replacement property has been received by the taxpayer to complete their exchange). I do not endorse refinancing one’s relinquished property, especially if a sale/exchange of the property is looming or anticipated to occur in the near future.
There is precious little authority available on this topic. However, these topics are discussed in section 4:14 of Tax Free Exchanges Under §1031, which states that:
“current case law favors the position that the taxpayer can obtain tax-free cash from an increase in debt on the taxpayer’s property prior to or after closing of an exchange.”
Additionally, the American Bar Association Section of Taxation has prepared Comments Concerning Open Issues in Section 1031 Like-Kind Exchanges. On point is Answer 2b set forth below:
[The italicized text below represents what I think is the current thinking among knowledgeable tax commentators.]
A-2b. POST-EXCHANGE REFINANCINGS.
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.
There is, however, virtually no authority addressing this issue. The key to the distinction between pre- and post-exchange refinancing is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for a pre-exchange relinquished property refinancing upon transfer of the relinquished property.
A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth. This is clearly the case in a post-exchange refinancing and there is no analytic reason to characterize such financings as being in lieu of fictitious payments by the seller of replacement property. Thus, we encourage the publication of a revenue ruling which indicates that money received in a post-exchange refinancing will not constitute "boot" in an exchange.
Defer the tax. Maximize your gain.
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