On the surface, refinancing a 1031 exchange property might seem counterintuitive. After all, the reason for executing a like-kind exchange is to use the equity from your relinquished property to acquire a new investment – your replacement property. Refinancing also can involve cashing out on equity.
Because of this, refinancing your relinquished property before embarking on a 1031 exchange is generally not recommended due to the potential tax implications and the potential for increased IRS scrutiny. But it is possible to perform a replacement property cash-out refinance after a 1031 exchange is completed.
If you’re considering this, be sure to adhere to these 1031 exchange refinance rules:
The goal of your 1031 exchange refinance should be to obtain the financial resources connected to your business (like property repair, making up a financial shortfall, or paying business-related expenses). If you can demonstrate a clear business purpose, the IRS will be less likely to scrutinize the exchange or refinance.
This requires paperwork. Keep meticulous records of how the funds are being used. And be sure to document how the expenses relate to your business.
The longer you can wait to refinance your replacement property, the less likely the IRS might question the action. There is no specific deadline or schedule between the conclusion of the exchange and the refinance process, though six months to a year can be considered a good “time buffer.”
To help reduce the possibility that your 1031 exchange refinance won’t automatically raise red flags, keep these actions separate. In other words, the refinance should be 100% unrelated to the exchange. The refinance must be documented as a separate transaction from the like-kind exchange. It also shouldn’t appear on the same closing statement as acquiring your replacement property.
The answer is yes. It is possible to refinance after a 1031 exchange if the replacement property is being refinanced and you consider timing, purpose, and process.
If done correctly, a 1031 exchange refinance on your replacement property shouldn’t pose any tax concerns or jeopardize the potential deferral benefits from the process. As a taxpayer aiming for maximum tax deferral through a 1031 exchange, refinancing your replacement property could be a viable strategy.