How to Handle Post-1031 Exchange Refinances

A common trap for the unwary in a 1031 exchange is the post-exchange refinance. In this article, we are going to talk about how to handle post-1031 exchange refinances.

Things to Remember with Refinancing 1031 Exchange Property

In a real estate transaction, many bankers are exuberant and want to loan you as much money as you qualify to borrow. They will loan you as much money as they can. But remember, in a 1031 exchange you need to find a home for your equity. You’ve got radioactive proceeds from the sale of your relinquished property. What do you do with radioactive material? You don’t put it in your own pocket. You’ve got to put that radioactive cash into the replacement property.

If you bring in $300,000 as a down payment on the purchase of a new property, when the banker would ordinarily only require a down payment of $100,000 – the banker is going to be scratching their head wondering why you aren’t borrowing more money. They may be unaware of the requirements of a 1031 exchange.

The best course of action is to tailor your loan to the 1031 exchange in question so you don’t overborrow at the moment of acquisition. That way you will acquire a property of equal or greater value, equity, and debt. Then in a subsequent transaction, you can go back and refinance the replacement property after the dust has settled.

CPEC1031 is Here to Help!

Our qualified intermediaries are here to help you through your next 1031 exchange! CPEC1031 has over two decades of experience facilitating 1031 exchanges of all shapes and sizes. We can help you through the finer details of your next like-kind exchange of real estate.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2022 Copyright Jeffrey R. Peterson All Rights Reserved

Post-Exchange Refinancing

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.

• Start Your 1031 Exchange: If you have questions about post exchange refinancing, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2022Copyright Jeffrey R. Peterson All Rights Reserved

Pre-Exchange Refinancing in a 1031 Exchange

Recently, a client came to us with a great question about pre/post exchange refinancing. Here's the situation in question:

My husband and I are considering doing a 1031 exchange on our property because of the current hot seller's market in Minneapolis. We own this property free of mortgages. I am now refinancing another rental property and was planning on pulling funds through a new HELOC on this investment property to cover the gap or buy down what we need to refinance the other investment property. If we do this and a month later, put the property on the market to sell and do a 1031 exchange, will that new HELOC cause a problem with the 1031 exchange?  

Avoid Pre-Exchange Refinancing

I would not suggest that you pull the equity of the property just prior to selling it as part of a 1031 exchange. Pre-exchange refinances done in anticipation of exchanges have been challenged by the IRS.

The reason that the IRS does not like pre-exchange refinances is that by pulling the equity out prior to the sale it is equivalent to taking a portion of the sales proceeds at the time of closing, which would be “cash boot” or taxable proceeds.

Most tax commentators prefer post exchange refinancing in a separate, subsequent transaction. The second mortgage should be put in a subsequent post exchange transaction. They may want some space and time between the end of the exchange, and the later refinance.

• Start Your 1031 Exchange: If you have questions about the 1031 Exchange Process, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2018 Copyright Jeffrey R. Peterson All Rights Reserved