May 11, 2023
By: Julia Mastrotto, Esq., Counsel

All too common is the question of refinance in proximity to an IRC Section 1031 exchange. The key takeaway being that a refinance cannot occur as part of a 1031 exchange. It should be noted that generally, a refinance is not a taxable event (subject to exceptions/limitations like most tax concepts); however, when a refinance is done in conjunction with a 1031 exchange, taxpayers should approach cautiously. Taxpayers are forewarned not to refinance their relinquished exchange property immediately before its sale; but equally, special care and consideration must also be taken if the taxpayer intends to refinance immediately after their exchange.

There is substantial risk to any pre-planned refinance of a 1031 exchange property, though a post-exchange refinance is generally more acceptable, especially when transacted in a separate tax year. The most conservative approach would be to complete your exchange, then (without pre-planning) refinance in the following tax year after the exchange concludes. It should be noted however, that clear rules explaining scenarios where a post-exchange refinance is acceptable have never been rendered by the IRS or the Tax Court/Court of Appeals. The following actions may be considered evidence of pre-planning: contacting lenders, submitting credit applications with respect to the replacement property as collateral, and preparing refinance documents before the exchanger owns the real estate.

The Courts in Fredericks[1] and Garcia[2] establish taxpayer-favorable precedent on post-exchange refinances. In Fredericks, the replacement had a larger mortgage than the relinquished property. To offset boot, the taxpayer refinanced the relinquished property pre-exchange. The Court ultimately approved of the pre-exchange refinance, citing the following requirements:

i.     Independent of the exchange;

ii.    Not conditioned on closing;

iii.   Dependent on creditworthiness of the taxpayer, rather than the cash buyer; and

iv.   Made sufficiently in advance of any contemplated exchange.

If the Fredericks requirements are not present, the IRS may be inclined to challenge the refinance as taxable boot. Most importantly, the reasons for refinancing should be unrelated to the exchange, and ideally motivated by an independent business purpose (for e.g., a use for the cash in the real estate business, refinancing original debt to get a better rate, or refinancing short-term debt a few months later – i.e. seller financing to a bank loan).

The Garcia case is different, most critically in that the taxpayer in Garcia did not receive cash out of the refinance. In order to avoid paying cash, the taxpayer asked the seller to increase the mortgage on the replacement property (this is sometimes referred to as an “assumed mortgage”). The taxpayer prevailed, and the IRS acquiesced.

“Where an integrated exchange plan was conceived and implemented and petitioners ultimately received only property in exchange for like-kind property, the interim steps taken to accomplish the exchange do not alter the results.”[3]

The 2011 case Dulles World Property, LLC v. Commissioner[4], involved a 1031 exchange wherein the taxpayer arranged (prior to closing) to refinance the replacement property the day after the acquisition. The exchange was challenged by the IRS, who alleged that the post-exchange refinance created taxable “boot.” Ultimately, the IRS dropped the case in May 2012, however without a positive court decision there is a risk that the IRS could again challenge the same.

The limited guidance regarding refinancing in proximity to a 1031 exchange is generally favorable to taxpayers. The strategy of refinancing a replacement property post-exchange can provide for planning opportunities even if the exchanger takes a conservative approach. It should be noted, however, that refinancing pre- or post-exchange is not risk free, and the foregoing strategies are not bulletproof should they be scrutinized by a taxing authority. Legal 1031 strongly recommends their exchangers consult with their tax advisor/CPA to plan accordingly. The information contained in this article should be analyzed critically and may be used to facilitate discussion but may not be construed as providing tax or legal advice.

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[1] Fredericks v. Commissioner, T.C. Memo 1994-27.

[2] Garcia v. Comm’r of Internal Revenue, 80 T.C. 491 (1983), acq, 1984-1 C.B. 1.

[3] Garcia v. Comm’r of Internal Revenue, 80 T.C. 491 (U.S.T.C. 1983).

[4] Dulles World Property, LLC v. Commissioner, Docket No. 13098-11, Filed August 18, 2011.

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