The rules of 1031 exchange can be fairly complex.
The IRS clearly states, for example, that in order for a property to qualify for a 1031 exchange, it must be equal to or greater in value than the one you sold. That means you need to take all of the money – including any profit- and reinvest it into the new property.
On the other hand, some investors prefer not to leave all of a property’s equity in the newly acquired property. They’d rather use that “extra” money to invest in ANOTHER commercial income property.
This factor is the reason why some investors choose to refinance a 1031 exchange property: instead of having their cash tied into the property, they can take out a loan on the property that can now be used for other investments.
Should You Refinance Before Or After a 1031 Exchange?
NEVER refinance a 1031 property before a sale!
Since the IRS has made it clear that any cash you receive after such a loan is taxable income, you’ll end up losing the benefit from the 1031 exchange.
So now you know that a 1031 exchange refinance should be done AFTER you close.
But how long after the close do you have to wait? Can you do it immediately? Or is there some sort of waiting period, in order to show the IRS that your original intention was not to take cash boot in your exchange? Because if the IRS does determine that the refinancing wasn’t done for legitimate purposes, than some of the money will end up being taxed.
How To Avoid Getting Hit By The IRS?
The IRS is concerned that the exchange and the property refinance are really one step, not two. This would mean that they are really one transaction. The first thing that needs to be done, then, is to be sure your intermediary records these as 2 separate transactions:
- The first document should show the closing of the 1031 exchange.
- While the second would be listed as a separate transaction showing the loan would be on a new statement.
You should also make sure that you can document that the loan was for a legitimate business purpose. One of the best excuses is if you can show that since the first loan was close to expiration, your plan was to set up a refinance just in case the 1031 fell through.
Of course, not many investors would be able to show that, so the next best proof for the IRS would be to show that you intended to buy a property that wasn’t part of the exchange.
The last type of proof that the IRS finds acceptable is to show that your intention was actually to get a better interest rate.
While these tactics are legitimate ways of avoiding an IRS audit, the best thing to do would be to try and put some time between the exchange and the refinance.
Doing so means you’ll be less likely to get audited.