WHAT ABOUT REFINANCING BEFORE OR AFTER AN EXCHANGE?
Sep, 2008
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The primary objective of most Section 1031 exchanges is to move an
investment from one property to another without incurring a tax
liability. In other words, take your money out of this property and put
it into that property and pay no capital gain tax. By following the
rules and regulations of Section 1031 properly, an investor can
accomplish that without having a capital gain tax bill.
Occasionally someone we work with will
ask a question like this: "How about if I refinance my property
and pull cash out, then exchange into another property? Borrowed
cash is tax-free, right?" The answer is yes, 
most of the time. However,
if an investor refinances close to the date of a sale and then proceeds
into an exchange, the IRS may reclassify the refinance proceeds
as boot taken out of the exchange (and therefore demand that tax be paid) unless
there was some fairly clear-cut business reason for the refinance
outside of simply wanting tax-free cash.
When contemplating a refinance after the purchase of the replacement property, care must be taken so that no commitments for a refinance are obtained prior to that closing. After the closing takes place, a refinance of the replacement property should be untouchable; if an independent business purpose for the refinance exists, so much the better.
It's safe to say that the more time that passes between the refinance and the sale (in the case of
a relinquished property) or the purchase and a refinance (in the case
of a replacement property), the better, although there appears to be no minimum amount of time required for either.
As always, it is critical to discuss
matters such as this with one's tax advisor for specific advice for
your circumstances and plans. Please feel free to ask us any questions
on this topic as well as any other exchange-related topics.