Refinancings Before and After § 1031 Exchanges

Cash (“boot”) received in a like-kind exchange results in taxable gain to the extent of realized gain. If the taxpayer exchanges Greenacre, whose adjusted basis is $1 million, for $1 million in cash and Whiteacre, worth $1 million, the taxpayer will pay capital gains tax on the entire $1 million cash received, since boot received equals realized gain.

Can the taxpayer can avoid the taxable gain in this situation by borrowing $1 million against Greenacre prior to the exchange? In that case, the fair market value of Greenacre, net of mortgage, would be only $1 million. In exchange for Greenacre, the taxpayer would receive Whiteacre, but not the $1 million in cash. Apparently, there would be no taxable gain, since the taxpayer received no boot in the exchange. Economically, two scenarios are nearly indistinguishable. In both cases, after the dust settles, the taxpayer will have $1 million in cash and a $1 million mortgage.

The Regs contain no prohibition on pre-exchange financing. However, the IRS may challenge such financing unless the debt is “old and cold.” Thus, while Regs. § 1.1031(b)-1(c)  treats a new loan obtained shortly before an exchange of relinquished property secured by that property as bona fide debt, the IRS may view that loan as cash received on the disposition of the relinquished property unless the loan has “independent economic significance.” A loan obtained to “even-up” the mortgages prior to the exchange solely to prevent gain recognition to one of the parties to the like-kind exchange would not appear to have independent economic significance.

To avoid IRS recharacterization, the refinancing (i) should be done by the exchanging party based on his own credit; (ii) should be possessed of a bona fide business purpose; (iii) should be made sufficiently in advance (i.e., “old and cold”) of any contemplated exchange to assure that the taxpayer is actually at risk; and (iv) the loan process should be commenced before the exchange is contemplated.

In contrast to pre-exchange financing, post-exchange financing poses less risk, since the taxpayer remains liable on the debt. No judicial or legislative authority appears to preclude a taxpayer from encumbering replacement property after the exchange. Still, to avoid the step-transaction doctrine, post-closing financing should be separated from acquisition financing. When closing title, excess financing proceeds should not be taken out at closing of the replacement property. Any refinancing should be done later and off the replacement property closing statement.

Adverse tax consequences can however flow from post-exchange refinancings if proper planning is not done to preserve the interest deduction on refinancing indebtedness. Since rules governing deductibility of interest depend on the type of interest involved, the proper classification of interst expense is essential to determine its deductibility. In general, interest expense on a debt is allocated in the same manner as the dcbt disbursed. Property used to secure the debt is immaterial. Temp. Reg. § 1.163-8T(a)(3).

Thus, investment of proceeds in tax-exempt bonds will result in a denial of the interest deduction on a mortgage against the replacement property. Likewise, use of refinancing proceeds for personal purposes will result in denial of the interest deduction. The deduction for “investment interest” is limited to “net investment income.” Investment interest is interest allocable to property held for investment, but not interest taken into account under the passive activity loss rules, or active business income. Therefore, even investments in taxable securities may result in denial of the interest deduction to the extent the interest expense exceeds the taxpayer’s investment income from such securities. Interest from active business income is subject to no limitations on deductibility.

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