Many investors engage in a 1031 exchange with the intention of deferring the full amount of their capital gains taxes and depreciation recapture. However, to do this, you must follow strict IRS guidelines. While there is no specific rule prohibiting refinancing a property when engaging in a 1031 exchange, doing so could jeopardize your tax deferral.
The Potential Problem with Cash-Out Refinancing
Under IRS guidelines, to receive a full tax deferral through a 1031 exchange, investors must reinvest the total sale price from the relinquished property – reduced by allowable exchange expenses - into a replacement property of equal or greater value. The investor also must not have any “net debt relief,” meaning that the amount of debt on the replacement property must be equal to or greater than the amount that was paid off when the relinquished property was sold. However, debt on the relinquished property can be replaced with cash on the replacement property.
If you take out cash at closing, these funds are considered “boot.” Similarly, the IRS has determined that refinancing in anticipation of sale is similar to pulling cash out at closing. As such, cash received at closing or as part of a refinancing before the closing may be subject to capital gains tax, depreciation recapture, state income taxes, and net investment income tax.
Refinancing a Relinquished Property Prior to Closing
If you are planning to relinquish a property that has a high amount of equity and low or no debt, 1031 exchange rules would require you to reinvest all the proceeds and match the debt.
Refinancing the property before selling it would allow you to pull out cash and pay off the current mortgage loan, replacing it with a new, larger mortgage. This also means that going into closing, you would have more debt and lower cash proceeds. When you purchase your replacement property, you would have a lower required investment amount, extra cash in your pocket, and full tax deferral.
While this may sound like a win, unfortunately, the IRS looks unfavorably upon it. Doing a cash-out refinance before selling a relinquished property is considered a step transaction, which is prohibited. Essentially, this means that if you can’t do something directly, such as taking cash out at closing, you also cannot do it by taking additional steps to circumvent the rules. However, this doesn’t always mean that the transaction would be taxable.
You may be able to get a full 1031 exchange if you can show that the refinance was not done in anticipation of engaging in a 1031 exchange. In this case, the more time between the refinance and the property sale, the stronger your claim may be. Typically, you’ll want to wait at least a few months.
You may also be able to show that you had “independent business reasons” for the refinance. For example, this may apply if the property needed structural repairs or your business was having cash flow problems.
Refinancing a Replacement Property After Closing
If you follow all the rules for a full 1031 exchange and later decide to complete a cash-out refinance on the replacement property, this should not impact your tax deferral. In this case, you’re taking out cash but still have an obligation to repay the debt, so the transaction does not result in a net increase in wealth. For this reason, the IRS does not typically disallow post-exchange cash-out refinances.
While there is no required waiting period before you can do a cash-out refinance on a replacement property, it’s still a good idea to make sure it’s not done concurrently with the purchase or to prearrange the refinance prior to the purchase. Otherwise, the IRS may question your intent.
Some Final Thoughts
Refinancing a property before or after a 1031 exchange can create some potential tax issues. Every situation is different, so it’s important to consult with your tax, financial, and legal advisors before executing a cash-out refinance in relation to a 1031 exchange.
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Because investor situations and objectives vary this information is not intended to indicate suitability for any particular investor.
This is for informational purposes only, does not constitute individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.
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