Refinancing Property Acquired in an Exchange

Refinancing Property Acquired in an Exchange

Refinancing Property Acquired in an Exchange

By: Michael Wiener

Refinancing properties allows real estate owners to presently benefit from their properties’ appreciation on a tax deferred basis. Because the borrower is obligated to repay the refinancing loan, refinancing a property by itself does not increase the borrower’s wealth and, therefore, does not result in taxable income. Rather, the borrower will only have taxable income if and when it sells the refinanced property in a taxable sale. However, if the property being refinanced was recently acquired in a section 1031 exchange, there is a risk that the net refinancing proceeds will be treated as unused proceeds from the sale of the relinquished property, which will result in taxable “boot”.

Consider the following example. Taxpayer sells Property A as relinquished property in an exchange for $20,000,000. At the time, Property A is encumbered by a $5,000,000 loan. The loan is paid off at closing and $15,000,000 of net sales proceeds is delivered to Taxpayer’s qualified intermediary. Taxpayer timely identifies Property B as its replacement property and enters into a purchase agreement to acquire Property B for $20,000,000. Taxpayer wants to finance the Property B acquisition with a $10,000,000 acquisition loan. However, this will cause Taxpayer to have $5,000,000 of unused proceeds from the sale of Property A, which is taxable boot. To avoid this result, Taxpayer satisfies its exchange requirements by applying all $15,000,000 of exchange proceeds towards the Property B acquisition and obtaining a $5,000,000 acquisition loan. Immediately after acquiring Property B, Taxpayer refinances the acquisition loan with a $10,000,000 refinancing loan and receives $5,000,000 of net refinancing proceeds from the lender of the refinancing loan. Taxpayer is in the same economic position as if it had obtained a $10,000,000 acquisition loan and received the remaining $5,000,000 of proceeds from the Property A sale. Should Taxpayer’s net refinancing proceeds be treated as proceeds from the Property A sale, resulting in taxable boot?

Many commentators, including the American Bar Association, have taken the position that, if the replacement property acquisition and the refinancing are executed as separate transactions, the refinancing should not generate taxable boot, regardless of timing. The reason is that the timing of the refinancing does not change the fact that, just like any other borrower that refinances a property, the taxpayer is obligated to repay the refinancing loan and, therefore, does not enjoy an increase in wealth and should not have taxable income. In this author’s view, this is the correct result.

Unfortunately, the California Franchise Tax Board disagrees with this view and has historically asserted that a pre-arranged refinancing for property acquired in an exchange will result in taxable boot. Therefore, it is best practice to not start the refinancing process until after the replacement property has been acquired. Further, a taxpayer will have a better chance of prevailing if the net refinancing proceeds are used for business, rather than personal, purposes.