Property with a large taxable gain may also have significant equity as well. Like cookies in a cookie jar, clients often want to figure out the easiest way to tap into that equity. Of course, easiest does not always mean the least expensive. Today we will tackle the first of eight most common methods.
- Borrowing from appreciated property prior to its sale.
The concern with receiving cash prior to or after a like-kind exchange is that the IRS may take the position that the taxpayer has received taxable boot based on a step transaction or substance-over-form theory. If an owner intends to refinance relinquished property prior to a like-kind exchange, the refinancing should occur prior to the date that the taxpayer enters into an agreement for the sale of the relinquished property. It is very important that the taxpayer be able to establish an independent business reason for the refinancing (i.e., separate and apart from tax-avoidance).
- PLR 8434015. The IRS ruled that cash proceeds received by a taxpayer from a refinancing just prior to the closing of a like-kind exchange constituted taxable boot to the taxpayer.
- PLR 200019014. The taxpayer refinanced the relinquished property approximately seven months prior to the exchange and in different tax years. The taxpayer represented in the ruling that no exchange was contemplated at the time of refinancing and that the refinancing was carried out to take advantage of lower interest rates. In addition, some of the taxpayer's refinancing proceeds were used to purchase more properties by the taxpayer. The IRS relied on a 1983 tax court case known as Garcia vs. Comm., stating that the refinancing had “independent economic significance" separate and apart from the like-kind exchange due to the fact that the taxpayer was taking advantage of lower interest rates and also purchased other properties with the debt proceeds.
- Behrens v. Comm., T.C. Memo 1985 – 195, a 1985 tax court memorandum decision. The Tax Court stated in dicta that a taxpayer could have avoided taxable boot from leveraging property at the time of the exchange if the taxpayer had simply encumbered the taxpayer's property through a third-party lender prior to or after the like-kind exchange.
- Fredericks v. Comm. T.C. Memo 1994 – 27. The taxpayer received loan proceeds from encumbering the taxpayer's relinquished property prior to the exchange. The Tax Court also indicated that the taxpayer received the loan proceeds separate and apart from the exchange. The taxpayer's reasons for refinancing prior to the exchange was that the taxpayer had attempted to refinance prior to the exchange and in any event, the taxpayer would have been required to refinance the loan if the exchange failed to close.