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A 1031 Exchange is a tremendous tax-deferment strategy used by many real estate investors. It is very important to follow the 1031 Exchange rules and to not create any red flags to the IRS.

You should avoid refinancing close in time to the date of an exchange. If you do the IRS may view any recent re-adjustment of debt as a tax avoidance trick and treat any loan proceeds received as taxable. Any new loan could be viewed as an artificial attempt to reallocate liabilities to avoid tax liabilities.

As an example, a taxpayer anticipating receipt of $500,000 in proceeds might want to only reinvest $400,000 into replacement property. The $100,000 that the exchanger does not want to reinvest will be taxed at the applicable capital gains rate.

A refinance loan arranged just prior to the exchange might be attempted to avoid this taxable result – i.e. just before exchanging, the taxpayer increases their existing loan balance by $100,000, puts the $100,000 cash into their own pocket and proceeds with the exchange while reducing their cash proceeds. They are thinking they have avoided the tax obligation on $100,000. However, this re-adjustment of existing debt would be deemed an impermissible tax avoidance mechanism by the IRS.

And trying to do a similar refinancing at the time of the exchange or shortly after, the same result may occur. As an example, a taxpayer who exchanges into a replacement property with a loan of $300,000 (required by the equities on the property he exchanged out of) shortly thereafter increases that new loan to $375,000 and obtains $75,000 cash. The result is what the taxpayer intended-i.e. $75,000 cash in pocket and a higher loan amount on the newly acquired property.

The IRS may treat this the same as a taxpayer failing to invest all their net cash proceeds in the replacement property as required.  They instead obtained a higher loan amount to put cash in their pocket.

There are times when doing a 1031 exchange refinancing is needed. If this is the case, careful planning is a must so the refinance becomes a minimal risk of a potential unfavorable tax liability.

Careful Planning Tips

A taxpayer refinancing close just befor, during, or shortly after an exchange should consider the following in structuring the loan transaction:

(1) Avoid integrating the refinance transaction with the exchange transaction.

Complete any pre-exchange refinance as far in advance as possible of the exchange. Try to do it before listing the property or before entering into any agreement related to the sale/exchange of the property.

Any post-exchange refinance should be a separate transaction from the exchange. Make sure that no agreements related to or in anticipation of the refinance are done or even negotiated during the pending 1031 exchange.

(2) If a refinance is close in time to an exchange, scrutinize the documents and the transaction as one to make sure the forms accurately reflect the essence of the transaction.

(3) Make sure the loan has an economic importance independent of the exchange (e.g., lower interest rate, more favorable terms, pre-existing need to refinance).

(4) Never use refinancing to reallocate existing liabilities for the sole purpose of tax avoidance.

The 1031 Exchange is an important tool in building wealth for real estate investors. But it is important to be fully aware of how and when you finance your investments.