Refinancing Property Prior to an Exchange

By: Michael Wiener

In a post published last year, we discussed the tax issues involved in refinancing a replacement property shortly after the completion of an exchange.  Similar issues exist when a taxpayer refinances its relinquished property shortly before an exchange.

Consider the following example.  Taxpayer owns Property A, which is under contract to be sold for $20,000,000. Property A is subject to $5,000,000 of debt.  Taxpayer intends to dispose of Property A as relinquished property in a 1031 exchange.  Shortly before the sale closes, Taxpayer refinances the $5,000,000 loan with a $10,000,000 loan, and receives $5,000,000 of excess refinancing proceeds.  At the closing, the $10,000,000 loan is assumed by the buyer and $10,000,000 of cash is delivered to Taxpayer’s qualified intermediary.  Taxpayer timely completes its exchange by acquiring Property B for $20,000,000, using the $10,000,000 held by its qualified intermediary.  Taxpayer also obtains a new $10,000,000 loan that is secured by Property B.

Given the proximity of the refinancing and the sale in the above example, Taxpayer will likely be treated as having received $5,000,000 of taxable boot from the sale of Property A.  The reason is that, under the so-called “step transaction” and “substance over form” doctrines, the refinancing and sale are treated as part of the same transaction.  Essentially, Taxpayer is in the same position it would have been in if (i) Taxpayer did not refinance Property A, (ii) $15,000,000 of net sales proceeds was delivered to Taxpayer’s qualified intermediary, (iii) Taxpayer acquired Property B for $20,000,000, using $10,000,000 of the proceeds held by its qualified intermediary and $10,000,000 of proceeds from a new loan, and (iv) Taxpayer’s qualified intermediary disbursed the remaining $5,000,000 of net sales proceeds to Taxpayer (alternatively, Taxpayer could have received this $5,000,000 directly from the Property A sale escrow).  In this case, Taxpayer would clearly have $5,000,000 of taxable boot.

In order to avoid taxable boot, a taxpayer that refinances its relinquished property prior to an exchange should make sure that the refinancing has independent economic significance.  The simplest way to achieve this is by refinancing the relinquished property as far in advance of the sale as possible.  While there is no required waiting period, the taxpayer should close the refinancing before entering into a sales agreement for the relinquished property or, if possible, listing the relinquished property for sale.

The independent economic significance of a refinancing can also be established by the existence of a business purpose (unrelated to the exchange), such as the imminent maturity of the existing debt on the relinquished property, the cash requirements of the taxpayer’s business, or, in one instance, taking advantage of lower interest rates (although the taxpayer in that case did not contemplate an exchange at the time of refinancing).

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