How NOT To Do A 1031 Refinance
Do not 1031 Refinance your Relinquished Property or Replacement Property if you want to avoid a taxable gain.
This is the position of the IRS, and the U.S. Tax Court agrees.
The only exception is when the refinance is done “in the ordinary course of business” and is not “in anticipation of an exchange.”
Otherwise, you should not 1031 refinance either of your properties.
The IRS applies the “step-transaction”doctrine and the “substance-over-form” principle to the 1031 refinance.
In doing so, the IRS is able to declare that the refinance is part of the Exchange and therefore the same as receiving part of the net sales proceeds as boot.
Therefore, the 1031 refinance loan proceeds are taxable as boot.
You can read all of the Private Letter Rulings and the U.S. Tax Court cases here on the REFINANCE page, where I have explained the position of the IRS and the decisions of the Courts.
HOW TO NOT 1031 REFINANCE
And yet, advice is rampant on the web that says that it is perfectly acceptable for you to close on the Replacement Property, and then immediately refinance the property, and take back all of the Net Sales Proceeds that the IRS required you to reinvest in the property.
This is totally incorrect.
For a long time, I could not find the source of this incorrect legal advice, but now, by comparing the common use of terms and phrases, I might have located the origin.
And I was even more stunned by the source than I had been by the advice.
DO NOT 1031 REFINANCE PRE-EXCHANGE PROPERTY
In 1995, the American Bar Association (ABA) Section on Taxation issued a Report on “Open Issues In Section 1031 Like-Kind Exchanges.”
(By the way, as a former member of the American Bar Association Section on Taxation, I was totally unaware of this Report, and also totally unaware that the Section even issued this type of report.)
In its “analysis” of the “landscape” of the Section 1031 Like Kind Exchange, the Report admits that “existing authority indicates that where a pre-Exhange refinance is completed as part of an integrated transaction which includes the Exchange, cash received by a taxpayer from a lender will be treated as cash received on disposition of the relinquished property.”
In other words, under existing law if you refinance your Relinquished Property prior to entering into a Section 1031 Exchange, the loan proceeds are taxable as boot.
This is correct.
A pre-Exchange 1031 refinance will create taxable boot for the taxpayer.
The authority cited is Long v. Commissioner, 77 T.C. 1043 (1981), which is also right on point.
It's Like A Seminar In A Book
DO NOT 1031 REFINANCE POST-EXCHANGE PROPERTY
But then the Report turns to the question of post-Exchange refinance, and goes completely off the rails.
The ABA Report declares that “post-Exchange refinancing should be less of a concern from a tax perspective than pre-Exchange refinancing,” and recites absolutely no authority for this position.
It goes on to say that “Even where a new loan is obtained at the time or immediately following a taxpayer’s acquisition of Replacement Property in an Exchange, receipt of cash by the taxpayer should not be treated as boot.”
This is baffling.
It is exactly the opposite of the IRS position on 1031 refinance, and contrary to all decisions by the United States Tax Court.
What is more baffling is that the Report then says, “There is, however, virtually no authority addressing this issue.”
Wrong. There is.
Apparently, the ABA Section on Taxation has not heard of the following cases regarding 1031 refinance and the principles that they stand for.
In the U.S. Tax Court, the determinations of the IRS “are presumed to be correct, and the petitioner has the burden to establish that they are erroneous.” Rule 142(a). Welch v. Helvering, 3 USTC 1164, 290 U.S. 111, 115 (1933).
In an Exchange of like-kind property, the taxpayer’s economic situation after the Exchange is fundamentally the same as it was before the Exchange. Koch v. Commissioner, 71 T.C. 54, 63.
“If the taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit.” House Report 704, 73rd Congress (1934) Jordan Marsh Co. v. Commissioner, 269 F.2d 453, 455-456 (2d Cir. 1959).
The underlying assumption of Section 1031(a) is that the new property “is substantially a continuation of the old investment still unliquidated.” Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 268 (1958).
Then the Report, after ignoring the Tax Court cases, launches into its own analysis/opinion of 1031 refinance.
It says that “a post-Exchange refinancing is different from a pre-Exchange refinancing because the taxpayer will remain responsible for repaying the post-Exchange indebtedness whereas the taxpayer will be relieved of the debt in a pre-Exchange refinancing.”
This is total nonsense.
Nobody “relieves” the taxpayer of the pre-Exchange debt. The debt is paid from the Net Sales Proceeds from the first closing in the Exchange.
The taxpayer’s Capital Gains are in the Net Sales Proceeds.
So, the taxpayer himself pays the debt on the pre-Exchange refinancing, he is not “relieved” of it.
And he pays the debt from his Capital Gains.
Therefore, the loan proceeds in his pocket that he got from a pre-Exchange refinance are actually his Capital Gains, because the loan that put the money in his pocket was paid off with Capital Gains from the sale of his Relinquished Property.
This is why the IRS uses the step-transaction doctrine to declare the loan proceeds to be taxable boot.
The taxpayer, instead of taking cash out at closing, has attempted to use two steps, first a non-taxable loan, and then a sale paying off the loan with part of the Capital Gains in the property.
Contrary to what the ABA Report claims, the taxpayer remained responsible for repaying the pre-Exchange refinance, and did pay it.
So, when the ABA Report says “a post-Exchange refinance is different from a pre-Exchange refinance because the taxpayer will remain responsible for repaying the post-Exchange debt,” it is just wrong.
The taxpayer remains responsible for paying both pre-Exchange and post-Exchange refinancing until it is in fact paid. And both loans will be paid from the taxpayer’s own funds.
The two situations are not different, they are identical.
The taxpayer borrowed his Capital Gains and put the money in his pocket. The money is taxable as boot.
After failing with this argument, the ABA Report attempts to show that the post-Exchange 1031 refinancing proceeds are not taxable because the borrowing “does not create income” because “the money has to be repaid and therefore does not constitute a net increase in wealth.”
In the first place, the same argument can be applied to the proceeds from a pre-Exchange refinancing, which the Report admits is taxable as boot.
But the argument really fails because the issue is whether or not 1031 refinancing is a step-transaction, the substance of which is to take boot out of the Exchange without paying tax.
And that issue has been settled.