Refinancing before or after a like-kind exchange may enable the taxpayer to extract tax-free cash in addition to reporting no gain on the exchange. Depending on the size of the mortgage encumbering the property to be replaced, refinancing may actually be necessary to avoid boot gain caused by debt relief. However, since refinancing during a like-kind exchange transforms what would otherwise be taxable boot or taxable debt relief into tax-free loan proceeds, the IRS may argue that the transaction is taxable unless an independent business purpose justifies the refinancing.

To illustrate preexchange refinancing, assume the relinquished property is heavily mortgaged but the replacement property is unencumbered or subject to only a small mortgage. Regs. §1.1031(d)(2) treats debt relief as cash received in the exchange. However, the Regs. also permit the “netting” of mortgages, suggesting that boot gain may be avoided by “evening up” the mortgages prior to the exchange. Encumbering the replacement property by an amount equal to the existing mortgage on the relinquished property would accomplish this equilization.  Will this strategy work?

The taxpayer in Wittig v. Comr., T.C. Memo, 1995-461 equalized the mortgages by encumbering the replacement property prior to the exchange, extracting cash from the new mortgage in the process. Since the assumption of the taxpayer’s liabilities with respect to the relinquished property equaled the new liabilities assumed by the taxpayer, the taxpayer reported no gain. PLR 9853028 concurred, stating that a new mortgage placed to acquire the replacement property could be netted against the existing mortgage on the relinquished property.

What if the loan is obtained shortly before the exchange? Although Regs. §1.1031(b)-1(c) would treat such as bona fide debt, Garcia v. Comr 80 T.C. 491 (1983) held that a loan obtained shortly prior to the exchange would be as cash received on disposition of the relinquished property unless the new debt had “independent economic significance.” Fredericks v. Comr, T.C. Memo, 1994-27 blessed pre-exchange financing where it was not conditioned on closing of title and was dependent on the taxpayer’s creditworthiness. Even here, the step-transaction doctrine could be invoked by the IRS if pre-exchange financing was in integral part of the exchange. See, e.g., Behrens v. Comr., T.C. Memo 1985-195. Ideally, refinancing should be entirely unrelated to the exchange.

In contrast to preexchange financing, no judicial or legislative authority appears to place restrictions on encumbering replacement property following an exchange. The ease of post-exchange financing might be explained by the fact that here the taxpayer remain economically answerable for the new debt. (In preexchange refinancing, the newly encumbered property is relinquished.)

Nevertheless, to avoid the step-transaction doctrine, title in the replacement property should be acquired before  engaging in post-exchange financing. Post-exchange financing proceeds should not be paid at the closing or appear on the closing statement. If additional construction draws will be made following acquisition of the replacement property, only the advance made by the construction lender (and not the draws) should appear on the closing statement.