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Refinance in 1031 Transactions

As we’ve seen, the basic concept of a 1031 exchange is simple, but certain exchanges can present many complex issues. We’ve covered complex topics such as the partnership installment note method, leasehold exchanges and others. Part of the reason for the complexity is the lack of clear authority. The IRS has issued documents of their own to provide more clarity. Ultimately, though, the IRS doesn’t have the final say on matters. Rather, Congress and the courts do. And Congress and the courts haven’t cleared up every issue pertaining to 1031 exchanges. There will never be a completely risk-free transaction. One step which has been known to create risk in 1031 exchanges is refinancing. Today, we’ll look at refinance in 1031 like kind exchange transactions so that we can mitigate those risks.

Risk is inherent in refinancing which occurs either before or after an exchange has occurred. Essentially, refinancing creates risk because it may trigger a taxable event. This can happen when the court determines that the refinancing only occurred in order to take tax-free cash out of the relinquished property. In this post, we will go over the mechanics of refinancing in an exchange and then provide suggestions on how to minimize risk. 

Mechanics of Refinance in 1031 Transactions: Before and After

The mechanics of refinance in 1031 transactions, prior to an exchange, are straightforward. The taxpayer pulls cash out of the relinquished property from a lender. This lender uses the equity in the property as collateral. Then, the taxpayer sells the property, pays off the loan, and then reacquires the debt on the purchase side of the exchange. It is important that the debt is reacquired, otherwise the taxpayer will pay tax on the debt cancellation. If this happens without any issue, we can see how it can be financially advantageous. The taxpayer has pulled cash from the equity without triggering a tax consequence. This may be even more beneficial if the new debt on the purchase side has a lower interest rate than the refinance loan.  

The mechanics of refinancing after an exchange are just as simple. After the replacement property has been acquired, the taxpayer leverages the equity to pull cash out. In some ways, refinancing after an exchange is even simpler because no new debt needs to be obtained after the refinance. In both cases, however, there is a risk that the IRS could view this as an abusive attempt to avoid taxation. 

Refinance in 1031 Transactions Should Have Independent Economic Substance 

There is no reason why a given property owner can’t leverage his or her equity to pull out a cash loan. In a 1031 context, however, the risk is that the IRS could characterize this as a “step transaction” to avoid taxable boot. What is happening is that the taxpayer is simply taking a tax-free loan rather than pulling cash out of the exchange proceeds. The exchange proceeds would be taxable as boot.

Step Transactions

As we’ve learned, the step transaction doctrine is a legal tool which courts use to scrutinize business transactions. This doctrine seeks to determine the true nature of a transaction, to determine its economic substance. If the purpose of the various steps of a transaction are solely to conceal the economic substance, then tax treatment could change. To avoid any problems, taxpayers need to establish that the refinance loan had “independent economic substance.” In other words, taxpayers need to be able to demonstrate that the purpose of the loan was not strictly to avoid any taxable events. It’s possible that a failed refinance could result in the funds being treated as boot for tax purposes. 

Time as One Significant Factor

There are several ways to establish independent economic substance. As with other transactions, courts will view the refinance loan in a 1031 transaction in wider context and take account of all relevant factors. For one thing, taxpayers should be sure that the refinance loan doesn’t occur too close in time to the exchange. This is true for refinances which occur before or after the exchange. If the refinance loan occurs too close in time, this may cast doubt on the idea that the loan had independent substance. But time is just one factor among many others.

Specific Business Purpose is Another

Another thing taxpayers can do is demonstrate that the loan was used for a specific business purpose. This can be done by keeping records of how the funds were used. If, for instance, refinance funds finance a trip to the Bahamas, this would be a strike against the taxpayer. But if the funds pay for the cost of advertising for a new business venture previously contemplated by the taxpayer, this would be a positive. In other words, each refinance in 1031 transactions requires a unique analysis, but time and specific business purpose are a couple of significant factors. 

Our New York City Tax Attorneys Can Help!

There are a number of cases which we can use to predict the outcome of future scenarios. This is why it’s so important to procure competent counsel prior to refinance in 1031 exchanges. A qualified tax attorney can help you determine your risk level. At Mackay, Caswell & Callahan, P.C., we understand the importance of doing adequate research prior to every risky transaction. A suspect refinance could result in hefty financial consequences, and so having qualified legal counsel is imperative. If you need counsel in this area, give our top New York City tax attorneys a call today. 

Image credit: GotCredit.com