Can you refinance relinquished property in a 1031 exchange?

Often times, I encounter investors who want to take advantage of the tax deferral offered by a 1031 exchange, but also want (or need) to receive money from the sale of the relinquished property. Ordinarily, any money received from the sale would be considered taxable boot.

Is there a workaround? Yes and no.

An investor could refinance the relinquished property immediately before the sale and receive the loan proceeds on a tax-free basis. However, then the investor would have to obtain replacement property that is subject to at least the same amount of debt as what the investor had on the relinquished property at its disposition.

But wait…what about the IRS? Yes, it is true that twenty years ago the IRS issued a private ruling (IRS Private Letter Ruling 8434015) that took the position that taking out debt on property immediately preceding an exchange might result in boot. However, since that time, the IRS has been unsuccessful in winning that position in court.

If you plan to refinance just before an exchange, be sure to discuss that strategy with your tax advisor. Also, keep in mind the following suggestions:

• Refinancing should not be seen as strictly for the purpose of “pulling out equity” to avoid capital gain tax
• The refinance should be kept separate from the exchange sale or purchase transactions
• The refinance should ideally be completed before the relinquished property is listed for sale

To find out how we can help you find and close on your next 1031 exchange property or to learn more about the exchange process and our qualified intermediary services, please visit our website.