Refinancing 1031 Property in an Exchange

To refinance or not to refinance: this is the common question many 1031 exchangers ask. By refinancing, exchangers are usually hoping to pull money (cash) out of their sale transaction to use for purposes other than investing in new 1031 property.

To answer the question, we need to understand the timing of the refinance. Based on the whether you, the taxpayer, are pulling money from the old, relinquished property or from the new, replacement property, the IRS has varying positions.

When refinancing the old property, a key 1031 exchange requirement drives the IRS’ position. The taxpayer cannot receive, touch or control the funds generated from the sale of the old property during the period until the purchase of the new property. Does refinancing the old property right before the exchange constitute “receiving money”?

The answer to this question depends, in part, on the timing of the refinance. If the refinance takes place a least a year before the sale, it is very doubtful that the IRS would try to argue that the refinance proceeds were income.

On the other hand, if the refinance loan was closed a week before the sale of the Old property, you can count on the IRS taking a close look at the loan transaction. If your loan application was made after you had accepted the contract to sell your property, you have a real problem because the IRS will clearly argue that the refinance was a blatant attempt to avoid the prohibition against touching the money.

But wait, you may still be able to come out OK in this situation if you are able to show that the proceeds from the refinance were used for a bona fide investment purpose. For example, if the proceeds were used to buy another investment property outside of the exchange, I would expect the IRS to approve since that property could have been part of the exchange.

Another example of a refinance transaction that I would expect to be blessed would be using the proceeds from the refinance to pay off, or down, a loan on another property, which has a much higher interest rate.

If you do something like this, my advice would be to keep clear records tracing the money from the refinance of the old property through to the purchase of the other property or the pay down/off of the loan.

This of course assumes that they audit you and that they pick up on the fact that the refinance immediately proceeded the closing of the sale.

On the other hand, if the refinance is on the New property, how long do you have to wait before you can refinance it? In the words of one of the former heads of Division 5, the IRS division which oversees 1031 exchanges, “you must wait at least ONE NANOSECOND”. Her definition of one nanosecond was that it was OK to sign the loan papers with one hand while your other hand was signing the closing papers for the purchase.

It doesn’t make sense for you to get a loan for the purchase of the property and then turn around a get another loan to refinance it so that you can pull some of the proceeds out. More than likely you’d end up pay double loan fees, and the refinance loan, because it was a refinance might be at a higher rate. The original loan may even include a no prepayment, or possibly a no prepayment for a certain period of time clause.

If you get a loan for the purchase of the New property that is larger than you need this solves the refinance/double fees/higher interest/prepayment penalty problem, but if the excess appears at the bottom of the Settlement Statement, or HUD-1, as “Balance due to purchaser”, the IRS will most certainly assume that this balance represents unspent exchange proceeds, and determine that this amount is taxable.

So how do you get around this problem? You have to show the IRS that the loan for the purchase came first, followed by the refinance draw down. In other words, show the loan like a construction loan with 2 draw downs: the first to close the purchase and the second a few minutes later for the excess proceeds.

The way we prove this for our clients is to have the closer prepare a separate Exchange Settlement Statement for the exchange showing just enough exchange proceeds to “zero out” the purchase. The HUD-1 Statement, which is the closing statement required by all lenders, must show all of the loan proceeds with the excess being disbursed to you. This is OK, because all we need to show is that the purchase to complete the exchange took place before the draw down of the excess proceeds. Our separate Exchange Settlement Statement shows this.

So, in conclusion, the general rule on refinancing exchange property and pulling the excess proceeds out, is that pulling proceeds from the Old property is dangerous, but that pulling proceeds from the purchase of the New Property is OK.