Refinancing Before and After an Exchange
When is it permissible to REFINANCE a property that is part of a 1031 Exchange transaction? The answer to this question is tricky because there are different types of refinance transactions, and there are different purposes for refinance transactions.
Typically, a RATE & TERM refinance taken more than one year before or after an exchange or where no cash is taken from the transaction generally will not cause a tax liability if the property is bought or sold as part of an IRC Section 1031 Exchange. This also still holds true if extra cash is added to pay down the debt on the property during the refinance as no cash is received by the taxpayer.
When it becomes an issue is when a taxpayer receives cash or other benefits other than rate or term and the refinance occurs within one year before or after an exchange. This is even more aggravated if a 1031 Exchange and the refinance BOTH occur in the same tax reporting period. What the IRS does NOT want you doing is performing a refinance on a property planned for an exchange (either before or after the exchange) whereas the purpose of doing the refinance is simply to avoid paying tax on the cash otherwise received during the exchange subject to tax as cash boot.
Here are two simple acceptable situations of many to help explain when a cash out refinance may be permissible:
You are selling a property and spending money for upkeep, deferred maintenance, or improvement. If you use your credit cards or ready cash, to replenish your cash accounts or pay off the debt from proceeds from the sale would put your in a taxable situation because you can only pay off debt required to close the property (liens recorded against the property). Personal debt or personal needs are never acceptable. Additionally, ANY cas taken by the seller at the close of a sale is taxable as cash boot. To avoid this, you may take a cash out refinance before you sell the property in question if you use 100% of those funds to perform deferred maintenance, upkeep, pay contractors or improve your property prior tosale. This goes for the property you purchase as well, keeping the proceeds of the refinance associated with a business purpose or reinvestment. Keep your receipts and report this activity to your tax advisor.
You sold a property as part of a 1031 Exchange with a high equity position. There may or may not have been debt on the property sold. You purchase a NEW property and complete your exchange. Shortly after you complete the exchange a new opportunity presents itself that you were not aware of during the exchange period or perhaps a property came back to the market you had an interest in. Regardless, you may do a cash out refinance for the purpose of acquiring new investment property or if a business need presents itself after the exchange. If you can avoid constructive receipt of the proceeds of the cash out refinance and allow the lender to credit the new purchase directly through your closing agent in this case is always best.
These are just a couple of examples. If you have questions or you would like to discuss your situation, please contact us right away as there are many opportunities to manage, mitigate or defer tax if you follow the rules and specific timelines associated with each solution. Time is your friend, and it can be your enemy sooner is always better than later.
