WHAT ABOUT REFINANCING BEFORE OR AFTER AN EXCHANGE?

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 similar to this: "How about if I refinance my property and pull cash out, then do an 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 would likely consider the refinance proceeds as cash taken out of the exchange (therefore being taxable) unless there was some fairly clear-cut business reason for the refinance outside of simply wanting tax-free cash.

The same goes for a refinance shortly after the purchase of the replacement property. Absent a definable purpose for the refinance, the IRS would quite possibly consider the refinance proceeds as boot, and again, expect taxes to be paid on that cash.

The essence of the matter is that the property owner should be able to substantiate an economic or business purpose for the refinance separate from merely getting around Section 1031 rules to pull out cash. The more time 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.

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.