For many real estate investors, the main goal of completing a 1031 exchange is to swap the equity in one property for an asset of equal or greater value while deferring capital gains taxes generated from the sale of the relinquished property.
The exchange process may sound straightforward, but it’s actually quite complicated due to the many IRS restrictions and deadlines to which exchangors must adhere. We occasionally work with investors who want to know if they can refinance an asset prior to or after an exchange. While possible, investors must be wary of refinancing timelines to avoid having the transaction classified as a step transaction that results in taxable boot.
Below we’ll cover some of the basics of the rules surrounding 1031 exchange refinancing.
1031 Exchange Refinancing Before Closing
Generally, it’s best to stay away from refinancing prior to completing a 1031 exchange since any receipt of proceeds from the sale of an investment property will generate a taxable event.
If you have a large amount of equity built-up in an asset and wish to refinance before an exchange, it’s best to do so well in advance of the exchange since those proceeds are not subject to taxation. However, if you refinance an asset and then quickly move to complete a 1031 exchange, you are creating a much different scenario, one in which you have increased your debt and lowered your cash equity position. This greatly changes the financial requirements of the exchange and is likely to raise red flags with the IRS since you are basically swapping new debt for tax-deferred cash.
Any refinancing done immediately prior to close of sale on a relinquished asset will likely be viewed as a step transaction. The end result is that refinancing in anticipation of a 1031 exchange will be viewed as part of the exchange itself, and any cash you have taken out will be taxable boot. The more time that takes place between refinancing and the exchange could create a safe harbor, though there’s no definitive timeline to avoid incurring a taxable event. At a bare minimum, you should strive for six months between refinancing and exchanging, and even longer is better.
There are ways to properly execute a refinance and a 1031 exchange in a compressed time frame. You must be able to demonstrate “clear business purpose” for the refinance, such as making needed repairs to the property (fixing a leaky roof, installing new mechanical systems, and the like), paying for key business expenses, or to alleviate any financial distress with the asset such as dwindling or negative cash flow. By properly documenting how you used the money, you may be able to avoid having the refinance classified as a step transaction that’s part of the 1031 exchange.
Refinancing After Completing a 1031 Exchange
You won’t create a taxable event if you refinance well in advance of an exchange. You can refinance a replacement property after an exchange, though. The key difference is because you aren’t increasing your personal wealth by taking on new debt on the replacement property.
Essentially, you aren’t creating a different -- and more advantageous -- financial scenario by refinancing post-closing. However, tax and legal experts caution not to mix the two processes -- start the refi process only after the closing on the replacement asset has been completed so that the two transactions are completely separated.
The Bottom Line
Foresight is important here. If you are thinking of cashing out some equity in an investment property that’s later destined to be part of a 1031 exchange, it’s important you do so well in advance of starting the exchange process. The equity in your relinquished property is supposed to be used to purchase a replacement asset of equal or greater value, allowing you to trade-up in asset class while deferring capital gains and other taxes. A cash-out refi for personal financial gain immediately before a 1031 exchange will create a taxable event, but you can complete a refinance in advance of an exchange if it’s for legitimate business purposes. Refinancing your replacement asset, meanwhile, won’t create taxable boot or threaten the integrity of your exchange because it doesn’t lead to personal financial gain since you’ve assumed more debt on the property.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.