In a 1031 Exchange, under the “step transaction doctrine,” refinancing to get equity out of a property before or after an Exchange could result in a taxable event since the IRS could take the position that the loan proceeds are taxable “boot.”  This is particularly problematic when the IRS believes that there was no independent business purpose for the refinancing.  However, there is case law which holds that refinancing of relinquished property may be permissible where the refinancing was undertaken for an independent business purpose, not solely for the purpose of tax avoidance, and had its own economic substance which was not interdependent with the sale and exchange of the relinquished property (Fred L. Fredericks v. Commissioner, TC Memo 1994-27, 67 TCM 2005 (1994)).

The IRS also issued a Private Letter Ruling in 2001 (Ruling 200131014) which addressed the issue of refinancing replacement properties after a 1031 Exchange.  In this Ruling, the Taxpayer exchanged agricultural property for hotel properties and refinanced the hotel properties, post-closing.  The lender required that each property be placed in a single-purpose limited liability company. While much of the discussion in this Ruling addressed whether or not transfer of the hotel properties into an LLC entity jeopardized the Exchange (the IRS ruled that transfers into single purpose LLCs did not), the IRS did not state any objections to the refinancing of the replacement properties. The American Bar Association has also provided guidance on this matter by taking the position that the proceeds of a refinanced replacement property after an Exchange is not taxable “boot” because the Taxpayer remains liable for repayment of the debt (unlike a pre-exchange refinance of the relinquished property where the debt would be repaid from the proceeds of the sale).

Regardless of the above, during an October, 2014 conference regarding 1031 Exchanges, the California Franchise Tax Board (“FTB”) stated its position that proceeds received by a Taxpayer in a post-closing refinance will be deemed taxable gain if the application to refinance is initiated by the Taxpayer prior to the close of escrow on the relinquished property. Therefore, if a California taxpayer wishes to cash-out equity in a replacement property after a 1031 Exchange, it seems prudent given these statements from the FTB, to wait until some time has passed from the closing date of the replacement property, before applying for a loan to refinance the new property.  As to refinancing a relinquished property prior to an Exchange, the FTB’s position appears to be “just don’t go there,” case law or no case law.

“This information is for educational purposes only and not intended to constitute legal advice. Every project and property is unique. Please seek legal counsel for advice specific to your project.”