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Show Me the Money: Refinancing Around a 1031 Exchange

show me the money For investors, one of the main reasons to use a 1031 exchange is so they don't have to pay any tax allowing them to earn a return on all of their equity going forward. For the gain deferral to be maximized, the exchange rules require that the purchase price of the replacement property be the same or greater than what was sold and all of the cash proceeds be used.  When there is little to no debt on the property, this can be particularly vexing to investors who would like to enjoy a bit of their hard earned equity.  Logically, many would like to at least get back their initial down payment or capital contribution, but the requirements of a 1031 make that difficult to do directly.  Because any gain is “top end loaded”, the first cash out is considered gain that is taxable. Is there a way to maximize the benefits of a 1031 while still freeing up a bit of equity?

Happily, there are ways to cash out some of the equity through either refinancing the replacement property or “pre-financing” the relinquished property.  The key is that this should not be done just prior or during the exchange period that begins the moment the relinquished property is sold and ends 180 days later.  One method is preferable to the other, but both are dependent on timing.

Some investors “pre-finance” the relinquished property to pull cash out prior to the sale.  In this instance, timing is critical, and we recommend that this be done at a minimum several months prior to ever offering the relinquished property for sale.  Great caution should be used when employing this strategy due to a tax court ruling against an investor that refinanced just prior to an exchange (IRS v. Garcia).  The court found there to be no other business reason for the financing except to cash out part of the equity in anticipation of the exchange, invalidating the 1031.  Though there are normal business reasons that might justify refinancing a property on the market for sale- such as a loan that becomes due and payable just before a closing or when an interest rate could be lowered --- we advise extreme caution. If the financing or refinancing allows you to cash out equity just before or at the relinquished closing, then the validity of your 1031 could be at risk.

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Refinancing after completing an exchange seems to be less problematic.  Perhaps because there are no cases to rely on, many investors and tax professionals are very aggressive when employing this technique.  There are some commercial loans that have a “cash out” feature the day after the replacement property is acquired.  For example, in an arrangement like this, the loan showing on the replacement closing statement might be $3 million; however, the next day, a new statement is executed showing a $5 million loan balance and $2 million of loan proceeds is distributed to the exchanger.  More conservative exchangers wait to start the loan application process after the replacement property has been acquired, while still others wait 12-24 months before pulling cash out. Ten years ago, off-the-record opinions from IRS reps from the national office suggested they were comfortable with immediate refinancing after an exchange; however, the personnel have changed and there now tends to be a more conservative view in DC.

It is our view that pulling equity out by financing or refinancing a property pre-exchange should be done several months prior to putting the property up for sale.  If an “after exchange” strategy is preferred, we recommend that the exchanger not take any active steps (i.e. make loan application) during the exchange period, but should at a minimum wait until the exchange is complete before seeking a loan.  It would be best to wait 12 months if possible.  Consider the example of an investor who uses a 1031 exchange to sell property with no debt for $2 million.  She then buys a $2 million replacement property using all of the cash.  One year after the exchange is completed, she gets a loan for $1 million on the replacement property.  The cash distributed to her is tax-free because converting her equity to cash is a non-taxable event.

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Every circumstance is different----so it is important that you get guidance from your tax advisor before using any type of financing to cash out equity around an exchange.