If you must refinance, do it at least six months before the property will go on the market, preferably longer. The same holds true for a property purchased in an exchange. It is best not to refinance directly after the purchase.
Both refinancing before or after a 1031 exchange might raise a red flag for the IRS, and the taxes avoided on the equity will have to be paid.
The outcome of a 1031 exchange is to use the equity from a relinquished property to purchase a new investment. Refinancing a property to pull out equity in the form of cash before the exchange defeats this purpose. Not only does it put cash in the investor’s pocket, it also reduces the amount they are required to spend on the replacement property because of the reduced equity.
If a refinance is done directly before or after an exchange is completed, the IRS might see it as the investor trying to avoid paying taxes on the cash taken out in the loan.
However, if refinancing for a legitimate business purpose, it is more likely to be viewed as acceptable by the IRS.
There are a few ways to measure if refinancing a loan would be seen as a business decision, instead of a method to avoid paying taxes.
Clear Business Purpose
If the IRS can determine that you are refinancing for business purposes, they will be less likely to scrutinize the tax benefits of the exchange. There are several ways to document this.
The best way to prove the funds are for business is by keeping meticulous records of what the funds are being used for. Also, note how the expenses directly relate to your business. For instance, the money might be used for repairs to the property, to relieve financial distress of a business, or to pay business expenses like marketing.
The Factor of Time
As noted above, the more time between a cash-out refinance and an exchange transaction, the better. Preferably six months or more before the home is put on the market and not done simultaneously with the replacement property transaction. Although, it is less risky to refinance the replacement property.
The refinance should be done as a completed unrelated transaction to the exchange. The closings cannot be combined, and the refinance must have complete economic independence from the exchange.
In the end, remember that the equity of a relinquished property should be used on a replacement investment property. It should not be cashed out in a refinance for financial gain unless it is for a legitimate business purpose.
Ultimately, refinancing a property too close to putting it on the market might cause the IRS to question the exchange. Refinancing after purchasing your replacement property in the exchange is less risky, as long as you are not planning on using the property in a new exchange.