Refinancing Before and After Exchanges
Refinancing to pull equity out of a property prior to or after completing a tax deferred exchange can result in a taxable transaction under the "step transaction doctrine." The IRS can argue that a "cash-back" refinancing, immediately before or after the exchange is completed, is just one step in the many steps of an exchange transaction and, therefore, the refinance loan proceeds should be taxable as boot in the exchange. This "step transaction" doctrine allows the IRS to recharacterize seemingly separate transactions into one transaction for tax purposes. The result is an unfortunate outcome for the Exchanger if the IRS believes that there was no independent business purpose for the refinance loan. In other words, the threshold question is "was the purpose of the loan nothing more than the Exchanger's desire to take cash out of the equity of either the relinquished or Replacement Properties without paying the capital gain tax?" Prior to the enactment of the current Treasury Regulations for IRC §1031, the proposed Regulations in 1990 prohibited “refinancing in anticipation of an exchange.” The final Regulations in 1991, however, omitted any reference to this refinancing prohibition because the IRS believed that it would create “substantial uncertainty in the tax results of an exchange transaction involving liabilities.
Although there is a mixed case law history on refinancing in conjunction with an exchange, current case law favors the position that the Exchanger can obtain cash by increasing debt on the property prior to or after completing an exchange. In Fred L. Fredericks v. Commissioner, the Exchanger refinanced the Relinquished Property two weeks after executing a contract to sell the property less than a month prior to the resulting exchange. Using the step transaction doctrine, the IRS argued that the refinance proceeds should be considered taxable boot. The Exchanger prevailed by showing that he had attempted to refinance the property over a two-year period. In this instance the Court concluded that the refinance transaction: (a) had an independent business purpose; (b) was not entered into solely for the purpose of tax avoidance; and (c) had its own economic substance which was not interdependent with the sale and exchange of the Relinquished Property.
Exchangers should carefully consider the following issues to avoid the pitfalls of the "step transaction doctrine": |
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The refinance loan should not appear to be solely for the purpose of "pulling out equity," thereby avoiding the capital gain tax that is otherwise attributable to non-exchange transactions. |
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As a rule of thumb, the refinance transaction should be separated from the exchange sale or purchase transaction to help separate the exchange from the refinance. |
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At a minimum, the Exchanger should attempt to complete the refinancing transaction prior to listing the Relinquished Property for sale. |
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The refinance loan and the sale or purchase in the exchange should be documented as separate transactions to avoid any "interdependence" of the transactions. |
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