How To Handle Refinancing

Many people jump into selling property just to obtain some money.  Depending on the tax consequences, this could be a very expensive method to obtain cash; which is why I always inquire as to the motivation for a proposed sale when consulting with clients.

Sales are subject to taxation because they are technically conversion of one kind of asset (real estate) for another kind (cash + debt relief).  The proceeds are for the seller to keep.

A loan, on the other hand, is merely the borrowing of cash for a limited amount of time, with a requirement to pay it back.  Since the funds received are not the person's to keep, loan proceeds are not considered to be taxable income.

One of the requirements for a completely tax free 1031 exchange is for all of the net proceeds from the original property to be reinvested into the new replacement property, with the exchanger not receiving any of it.  If some of the cash is taken out from the disposal by the exchanger, it is subject to tax.   This requirement does discourage a lot of people from doing exchanges because they either don't want to put all of their net equity into new property and/or they don't want to pay any taxes on the deal. 

If things are set up properly, it is possible to have the best of both worlds, tax free cash and a completely tax free exchange, by refinancing either the original property or the replacement property.

The key to doing this properly and avoiding any IRS problems is to make sure the refi is a completely separate transaction from the disposal or replacement leg of your exchange.  If the refi appears to be connected to the exchange itself, IRS will consider any cash as taxable non-like kind proceeds (aka Boot), which will be subject to tax.

The other thing to keep in mind is that the refinance of the original property's debt will require a higher mortgage on the new replacement property in order to make sure the exchange meets the equal or higher reinvestment test.

Several years ago (around 1988-89), there was a proposal among some of our rulers in Congress to consider cash received within a certain number of days before or after an exchange to be the same as cash received from an exchange and thus subject to tax.  They even had a name for this: "Refinance In Anticipation Of An Exchange."  Luckily for those of us who believe in lower taxes, this was never enacted into law and has not even been seriously considered since then by our rulers in DC.

Obviously, the longer amount of time that elapses between the refi and the exchange, the less likely there will be any attempt by IRS to categorize the money as disguised exchange proceeds.  As in all tax matters, the burden of proving that what you did was proper rests with the taxpayer.  IRS agents don't have to prove that you did anything wrong.  If they make an accusation, you have to prove that it was legit.

KMK