Cash Out Refinance After 1031 Exchange

Are you the owner of a multifamily housing unit?  An office complex? A trendy shopping center?

Valuable commercial real estate properties can present their owners with quite the predicament, especially if the market is hot and the owner/investor is looking to sell.

In the above scenario, you know what happens next — the business owner is typically hammered with a hefty capital gains tax bill upon the sale of the property.

Fortunately, commercial real estate transactions can effectively integrate with a beneficial tax law that allows business people to defer paying capital gains taxes. It’s called a 1031 Exchange, in reference to Section 1031 of the Internal Revenue Service (IRS) code.

What is a 1031 Exchange?

A 1031 Exchange, also known as a like-kind exchange, is a complex situation where real estate, taxes, contracts, finance, partnerships, and a number of other legal and business issues might all come together, and transactions can range from clean and manageable to unnecessarily complicated.

Simply put, the 1031 Exchange is a strategy used by taxpayers to defer capital gains taxes on the sale of a business or investment property. No gain or loss on the transaction is recognized provided that the property is exchanged solely for a property of a like-kind, which is to be held for the purpose of trade … or for investment, the code states.

The IRS says these exchanges have long been permitted under the Internal Revenue Code, as long as you make a like-kind exchange. Properties are deemed to be of like-kind if they’re of the same character or nature. This holds true to the IRS even if the properties differ in grade or quality.

For example, an apartment complex would generally be like-kind to another apartment complex. A warehouse can be exchanged for a warehouse. However, property in the United States cannot be part of a like-kind exchange with property outside the country.

Understanding Capital Gains

In order to fully understand like-kind exchanges, it’s essential to also have a working understanding of capital gains.

The definition of a capital gain (according to The Street) is: a type of income realized upon the sale or exchange of a capital asset.  

Capital gains tax is imposed by the IRS on the sale of certain assets, including commercial real estate. But typically, if you transfer property to another party as a like-kind exchange during the current tax year, you can defer the gain (or loss) on the exchange and must file IRS form 8824 with your tax return for that tax year. The filing requirement extends to taxpayers that are either an individual, a corporation or a partnership.

The key benefit of a 1031 exchange is that the investor is permitted to defer the capital gains tax payments that would otherwise accompany a conventional sale. But make no mistake, if you’re entering into a 1031 Exchange, you’ll want qualified intermediaries to provide sound advice and closing services. 

Refinancing and 1031 Exchanges

There are do’s and don’ts when it comes to refinancing a property that will likely be part of a 1031 Exchange. Most importantly, experts across the board are unanimous when it comes to offering advice about conducting such business: discuss your plans with your tax advisor(s) and don’t refinance “in anticipation” of the exchange. Above all, any refinance must be treated as an independent business purpose.

In dispensing such advice, the professionals at Investment Property Exchange Services, Inc. cite Fred L. Fredericks v. Commissioner (1994), in which one party refinanced a relinquished property a mere two weeks after effectuating a contract to sell and less than 30 days prior to the exchange.  The United States Tax Court was left to determine if the IRS was right to recognize any gain on the exchange and whether Fredericks was liable for paying tax.

In this case, the IRS used what is known as a step transaction doctrine to argue that the refinance proceeds should be considered taxable. But Fredericks prevailed when it was proved an attempt was made to refinance the property over a two-year period. The Court ruled the refinance had an independent purpose and the transaction was not made for the sole purpose of tax avoidance.

The lesson to be learned is that the IRS does not look favorably on a step transaction, which it sees as attempting to effect a favorable change to debt and equity numbers and leans toward tax avoidance.

Cash Out Re-fi After The 1031 Exchange

If you’ve fully invested in a 1031 Exchange, we’ve already reached the understanding that generating cash on or around the time of selling the relinquished property is discouraged and should not be pursued, as any sums paid at closing would be subject to tax.

As an alternative, refinancing the replacement property after the exchange is seen by many as the way to move forward. This should not result in any tax issues and experts suggest it will not jeopardize the tax deferral on the transaction. The logic is that anyone refinancing after a 1031 exchange retains the debt obligation on the replacement property as an offset to any receipt of cash.

A Final Word on Refinance and the 1031 Exchange

If you’re considering a 1031 Exchange and cash out refinance and still have questions, remember this — the IRS will look upon the transaction and scrutinize it effectively. They’ll be asking if the purpose was for a legal exchange under the 1031 code, or if your desire to cash out the equity of either the relinquished or the replacement properties was simply to avoid paying tax.

If government tax professionals conclude the latter and not the former, you might find yourself in U.S. Tax Court as well. However, if you follow this list as a rule of thumb, you should effectively be able to navigate the 1031 Exchange and subsequent refinance with no problems:

  • Always remember that any refinance transaction should be completely separate from the exchange or purchase transaction(s). This will support any argument that they were not interconnected. 
  • Relative to the advice above, the refinance should absolutely be documented as a separate transaction. The paper trail will help to avoid any question of whether the transactions were interconnected.
  •  Experts agree that is less risky (and a better business objective overall) to refinance the replacement property and not the relinquished property. This should be done through a separate post-closing transaction.
  • Finally, you should always be able to demonstrate a cash-out refinance (on either property) has an independent business purpose.

As a final note, it is incredibly important for taxpayers and those involved with a 1031 Exchange to carefully review the like-kind exchange rules and understand how these rules should apply to the unique set of facts and circumstances of the deal. It’s best in these cases to consult advisors and tax professionals so the transactions aren’t delayed and potential legal hiccups are avoided.

References

Author: Bryan Dornan

Bryan Dornan is a financial journalist and currently serves as Chief Editor of Cash Out Refi Tips.com. Bryan has worked in the mortgage industry for over 20 years and has a wealth of experience in providing mortgage clients with the highest level of service in the industry. He also writes for RealtyTimes, Patch, Buzzfeed, Medium and other national publications. Find him on Twitter, Muckrack, Linkedin and ActiveRain.

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