SAFELY REFINANCE A 1031 PROPERTY

Refinancing Before or After an Exchange

Seasoned 1031 exchangers know that if they receive cash in an exchange, rather than investing it in the replacement property, the transaction will be partially taxable. It's not surprising, therefore, that many real estate investors plan to refinance the relinquished property immediately before an exchange, or the replacement property immediately after an exchange, in order to get cash out of the property without being taxed.

Although it is possible to refinance before or after an exchange without triggering tax, investors should carefully consider their options before doing this, because the IRS could take the position that the refinancing should be taxable when it is done to get around the 1031 exchange rules rather than for a separate business purpose. Despite this risk, an investor can refinance the relinquished or replacement properties and get tax free cash, as long as he establishes that the refinance had "independent economic substance" and wasn't done merely to get around the 1031 exchange rules.

Every situation is different, and investors should discuss their plans with their tax advisors, but here are a few suggestions that may help investors structure a refinance so that the funds received are not taxable:

The loan should have a clear business purpose (other than just getting the equity out of the property) and that business purpose should be well documented in the investor's files.

The refinance should occur as far away in time as possible from the closing of the relinquished or replacement properties.

The refinance should be documented as a separate transaction and should not appear on the same closing statement as the closing of the relinquished or replacement properties.

Some tax advisors believe that it is better to refinance the replacement property after an exchange rather than refinancing the relinquished property before an exchange. In any event, it is important to consider the risks and discuss your plans with your tax advisor.