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April 22, 2014

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

#1031 Advisor

Finally, we discuss the eighth most common method used to take advantage of the equity in a property sold in a like-kind exchange.

  1. Using a line of credit to acquire an investment property.

    Occasionally, an owner will acquire a property using funds from a line of credit. In the sale of a property, the debt paid off on the sale of the property should be a liability of the subject property. Typically, this means that the debt is secured by a mortgage on the property to be sold. To protect the client from having the payoff of the line of credit being treated as taxable boot, the client should record a mortgage against the property to be sold.

    Refinancing Subsequent to the Exchange.

    As long as the taxpayer does not refinance simultaneously 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 the like-kind exchange is Garcia vs. Comm., 80 T.C. 491 (1983). In Garcia vs. Comm. 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.

    The Court, however, 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 Garcia vs. Comm. 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.

    The IRS issued a recent favorable ruling with respect to refinancing subsequent to an exchange. 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 worth noting that the refinancing was to occur in the taxable year subsequent to the exchange.
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