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April 15, 2014

Taking Cash Out before, during and after a Section 1031 Exchange (Part 3 of 4)

#1031 Advisor

So far, we have discussed five of the eight most common methods used to take advantage of the equity in a property sold in a like-kind exchange. If you would like to catch up with this discussion click on the following link, 1031 Exchange News Briefs, to read the previous newsletters. Today we look at the next two.

  1. Borrowing a larger amount for the purchase of replacement property and receiving cash at the end of the exchange.

    Borrowing more cash than is needed to acquire the replacement property causes the exchange to be taxed in two different ways:

    1. First, in addition to applying 100% of the equity received on the sale toward the purchase of a replacement property, the tax rules also provide that the taxpayer cannot borrow more cash than is needed to acquire the property (unless the taxpayer is improving the property through an improvement or construction exchange).
    2. For example, a property is being sold for $500,000 subject to a $250,000 loan. The net proceeds will be $250,000 which will be used to acquire a new property for $500,000. The taxpayer borrows $250,000 toward the purchase price. If the taxpayer borrowed $300,000 instead, then there would be $50,000 left in the exchange account. Hence, the taxpayer would be taxed on the $50,000 excess borrowing. This is why loan costs must be paid by the taxpayer, not with extra loan proceeds.
  2. Borrowing after the purchase of the replacement property.

    As long as the taxpayer does not refinance simultaneous with the exchange, under most facts, the taxpayer can refinance the taxpayer's replacement property subsequent to the exchange and receive cash from the refinancing which is not considered taxable boot. An important case regarding refinancing in connection with a like-kind exchange is Garcia vs. Comm., 80 T.C. 491 (1983).

    1. In Garcia vs. Comm., 80 T.C. 491 (1983), The seller of the replacement property further encumbered the replacement property for the purpose of equalizing the equity of the relinquished property and the replacement property. The IRS indicated that the increase in the mortgage on the replacement property was taxable boot to the taxpayer because it was an artificial reallocation of liabilities for the purpose of tax avoidance. However, the Court found that the increase in the mortgage on the replacement property should be respected because it had “independent economic substance." The taxpayer neither refinanced prior to the exchange nor after the exchange in this case. However, the Court's test for determining whether or not taxable boot was received (i.e., the “independent economic substance" test) is frequently applied in determining if refinancing should be treated as taxable boot.
    2. In PLR 200131014, the taxpayer refinanced the replacement property subsequent to the exchange and the proceeds were used solely for the purpose of advancing the taxpayer's business objectives. However, it may be noteworthy that the refinancing was to occur in the taxable year subsequent to the exchange.
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