Can You Purchase a 1031 Exchange Property with Seller Refinancing?

Seller Refinancing and 1031 Exchanges

The 26 U.S. Code § 1031 is relatively straightforward. Identified as “Exchange of Real Property Held for Productive Use or Investment,” the process focuses on disposing of an owned piece of real estate (i.e., the "relinquished” property) and swapping the proceeds into another real estate asset (i.e., the “replacement” property). 

While the exchange process is basic, various rules and regulations exist to ensure that the tax-deferral exchange process doesn’t turn into a potentially taxable event. If you are the exchanger, you must adhere to specific deadlines and ensure that the replacement property/properties you’re targeting are of equal or greater value.

Additionally, if you’ve refinanced your relinquished property before exchanging it—or are considering doing so—be aware that this could raise a red flag with the IRS.

A Brief Overview of Refinancing

Refinance is defined as paying off and replacing your existing loan with a new one, generally with different terms. You might decide to refinance a property for the following reasons:

• To improve on your current loan’s interest rate, or to change it from variable to fixed
• To extend your current loan’s maturity date
• To gain access to your equity in the form of cash

The first two points are considered rate-and-term refinance, while the third one is known as cash-out refinance. An interesting fact connected to a cash-out refi is that the cash you obtain from your property’s equity isn’t taxed. Instead, the IRS considers that cash as part of your loan. 

As such, the IRS is also suspicious if you complete a cash-out finance of your relinquished property before putting it into a 1031 exchange. 

Red Flag Warnings

We’ve stated this plenty of times in previous blogs: the like-kind exchange is a tax-deferral strategy, in which you defer capital gains taxes on the sale of your relinquished property. But if you’ve taken cash from your property through a cash-out refinance, you end up with less equity, meaning you wouldn’t have to spend as much on a replacement property. Meanwhile, there is all that cash from the refi, which can’t be taxed. 

From the IRS’s point of view, it’s not a great leap to consider that a refinance completed before an exchange was done to reduce equity and avoid paying taxes. But you can let the IRS know that your refinancing activities are legitimate in the following ways:

Demonstrate a clear business purpose. The IRS is more likely to approve your refinance activities before the 1031 exchange if you are crystal clear that the process is directly tied to business reasons. If you’re using the cash from a refi to fund your payroll or make repairs to your premises, be sure to carefully document everything.

Expand the time frame between activities. The closer the refi activities are to your exchange, the more suspicious it might appear to the tax entities. Be sure your cash-out refinance concludes at least six months or longer before your planned exchange.

Conduct separate transactions. Keep your refinance and 1031 exchange processes apart from one another. They need to be unconnected, unrelatable deals. Separate bank accounts, closing dates, and personnel for each action can help alleviate IRS suspicion.

To summarize, refinancing your property can be beneficial. But doing so in context with a 1031 exchange could create issues. As such, it’s important to discuss the situation with your tax professional before making a move.