If you do a 1031 refinance on your Relinquished Property prior to closing a Section 1031 Exchange, or if you do a 1031 refinance on your Replacement Property after closing a Section 1031 Exchange, you will have taxable “boot” and a new man in your life, an IRS Tax Examiner.
Now, I know, you will be told by those urging you to use their services that a cash out refinance is perfectly legal, and easy money, and people do it all the time, and it has nothing to do with the 1031 Exchange itself, but read on.
These promoters claim that the IRS has not taken a clear position regarding a pre-Exchange or post-Exchange 1031 refinance, but this is incorrect.
In 1990, the IRS proposed an Amendment to Reg Section 1.1031(b)-1(c), which covers “Receipt of other property or money in tax-free exchange,” and specifically subsection (c).
The purpose was not to change anything, but to simply clarify situations where misinformation had created confusion among the taxpayers as to what the exact requirements were regarding refinancing in 1031 Exchange situations.
Subsection (c) provides that consideration received in the form of assumption of debt on the property being sold is treated as “other property or money” received by the Exchangor.
The Service wanted to add to this definition of “other property or money” the pre-Exchange and post-Exchange 1031 refinance, making those loan proceeds also taxable boot received by the Exchangor.
The Service calls this the “in anticipation of exchange” concept.
The IRS said the Amendment to the wording of the Regulation that they were proposing would be “a clarification of existing law.”
Therefore, in 1990 and previously, the IRS had taken a very clear position on the pre-Exchange and post-Exchange 1031 refinance, and that position was that the loan proceeds represented boot and were taxable.
The Amendment was ultimately not included because it was felt that it might cause confusion with the netting of mutual assumptions of liabilities.
But the IRS continued to hold the position, and four years later it was certified in the landmark case of Fredericks v. Commissioner, 67 T.C.M. 2005.
Fredericks involved a taxpayer who did a 1031 refinance of his property a week after signing the contract to sell it in a Section 1031 Exchange, and “cashed-out” $2,020,407.33.
The IRS argued that this constituted the receipt of “other property or money,” the same position they had taken in the 1990 proposed Amendment to the Regs, and that the money was taxable as boot.
The Tax Court agreed that it would be, except that the taxpayer had reasons for refinancing the mortgage that were unrelated to the exchange, and this constituted an exception to the rule. Because the existing loan was maturing, and interest rates were rising, the taxpayer had been trying to refinance for over a year.
It's Like A Seminar In A Book
IF YOU USE A DELAWARE STATUTORY TRUST, TRIPLE NET LEASE, OR A T-I-C, YOU MUST HAVE THIS EDITION.
But the point of the case is that the IRS was still exerting the same position regarding a 1031 refinance, and the Tax Court was not rejecting it: if a refinance is “in anticipation of an exchange” and “without primary business substance,” it constitutes a step-transaction resulting in the receipt of boot.
The cases regarding refinance in the Section 1031 arena are very interesting, and worth a look.
If you are not familiar with any of the terms of Section 1031, check out our Dictionary.
SUMMARY: Selling a capital asset usually results in capital gains income. This income is taxable. Section 1031 permits you to defer the capital gains tax if the capital asset was “held for productive use in a trade or business or for investment” and if you replaced it with a like-kind property “which is to be held either for productive use in a trade or business or for investment.”
If you retain part of the net sales proceeds instead of reinvesting them, this portion is taxable as “boot.”
If you do a pre-Exchange or post-Exchange 1031 refinance of either property, in anticipation of the exchange and not in the ordinary course of business, the IRS will invoke the step-transaction doctrine, treat the refinance as part of the exchange, and characterize the loan proceeds as boot, and therefore taxable.
In U.S. Tax Court, the positions taken by the IRS “are presumed to be correct, and petitioner has the burden to establish that they are erroneous.” Rule 142(a); Welch v. Helvering, 3 USTC 1164, 290 U.S. 111, 115 (1933).
So, you will have to provide proof that the loan proceeds are not boot.
But the Court recognizes that there are exceptions to the rule, even allowing the 1031 refinance of the Relinquished Property one week after the taxpayer entered into a contract to sell it. But the circumstances were special. Fredericks v. Commissioner, 67 T.C.M. 2005.
There are other situations in which the Tax Court has agreed that the taxpayer has presented an exception to the rule, and even situations where the IRS has given advance approval of refinancing in Private Letter Rulings.
They all involve exceptions to the rule. But there is a rule. If there were no rule, there could not be exceptions.
READING TIME: Approximately 6 minutes.
1031 REFINANCE AND BOOT
Let’s look at why a refinance causes you to have taxable boot.
Internal Revenue Code Section 1001(c) requires that the entire amount of the gain or loss on the sale or exchange of property shall be recognized.
Section 1031(a), however, provides for the nonrecognition of gain or loss when property held for productive use in a trade or business or for investment is exchanged solely for like-kind property that is to be held for productive use in a trade or business or for investment.
“…exchanged solely for like-kind property” means that all of the net sales proceeds from the sale of the Relinquished Property are used toward the purchase of the Replacement Property.
If you take out part of the net sales proceeds after closing on the sale of the Relinquished Property, this money is considered “boot” received, and is taxable.
If you attempt to avoid the taxation by doing a 1031 refinance on either the Relinquished Property prior to selling it, or refinancing the Replacement Property after buying it, you are doing so “in anticipation” of the Exchange.
These loan proceeds are also taxable as “boot” because the refinance was done “in anticipation of an exchange” and “not in the ordinary course of business.”
The IRS has always held this position and the Tax Court has never rejected it.
Nor is it likely that the Tax Court ever will, because in U.S. Tax Court, the determinations made by the IRS “are presumed to be correct, and petitioner has the burden to establish that they are erroneous.” Rule 142(a); Welch v. Helvering, 3 USTC 1164, 290 U.S. 111, 115 (1933).
The IRS bases its position on the “step-transaction” concept, where the individual steps in a transaction are ignored, and the total substance of the transaction is looked at, applying the related concept of “substance over form,” where the Court may view transactions as a whole even if the taxpayer accomplishes the result by series of steps. Commissioner v. Court Holding Co., 324 U.S. 331 (1945).
In Commissioner, the Court said, “The incidence of taxation depends on the substance of the transaction.”
The decision went on to explain:
“To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress.”
The “step-transaction” concept and the “substance over form” principle are used extensively by the IRS.
1031 REFINANCE IN COURT CASES
The IRS has never claimed that every single case involving refinance results in the taxpayer receiving boot.
The IRS accepts that a refinance can be done in the ordinary course of business and for a legitimate business reason.
Their position is that if the refinance is done in the ordinary course of business, and is not done in anticipation of an exchange, then it is permissable.
This issue is what the court cases are all about.
The taxpayer does not claim that he has a right to do a 1031 refinance at any time because there is no rule, but rather that there is a rule, but he qualifies for an exception to the rule.
The taxpayer is actually accepting the fact that there is a rule against the pre-Exchange and post-Exchange refinance, by claiming an exception to the rule.
If there were no rule, there could not be an exception to it.
And actually, there are two rules- one for Relinquished Property, and one for Replacement Property.
1031 REFINANCE OF RELINQUISHED PROPERTY
Taxpayers going into court with a claimed exception to the refinance boot rule usually have a pretty good case before they go to all of the trouble and expense of a court case.
Sometimes they have a great case.
In the Fredericks case above, the taxpayer refinanced his property one week after entering into an agreement to sell it, and the Tax Court backed him up.
The Court held that the refinancing was unrelated to the exchange and thus the loan proceeds were not taxable boot, because the taxpayer’s existing loan was almost due, and that he had been attempting to refinance for some time prior to the sale.
In Private Letter Ruling 200019014, the taxpayer asked the IRS to give approval to a situation where the taxpayer, a Partnership, had done a 1031 refinance of the property eight months before and made a partial distribution of the proceeds to the partners, but the taxpayer was not anticipating selling the property in a Section 1031 Exchange at the time.
Now the taxpayer wanted to do a Section 1031 Exchange, but wanted the IRS to give an opinion first.
The IRS gave its blessing to the exchange, saying:
“The refinancing issue in the present case is similar to Fredericks because the refinancing in Year 1 had an economic significance that is independent from the proposed exchange. Taxpayers received lower interest rates on their loans, and the proceeds from the refinancing were used by the partners to purchase more properties. Accordingly, the proceeds of Year 1 refinancing will not be considered as payment of boot in the exchange transaction.”
PLR 200019014 has three points to take note of:
1.) Even though the 1031 refinance occurred 8 months before the proposed exchange was to take place, the IRS considered that amount of time within the lookback period for declaring loan proceeds from a pre-Exchange refinance to be taxable boot,
2.) The IRS is adamant in imposing the refinancing rules to pre-Exchange and post-Exchange loans, and
3.) The IRS is willing to bless a refinance if it meets the requirements that it have independent business purpose and that it not be in anticipation of an Exchange.
1031 REFINANCE OF REPLACEMENT PROPERTY
There are many more Private Letter Rulings and U.S. Tax Court cases involving pre-Exchange situations than post-Exchange situations.
This is because in a pre-Exchange refinance, the financing has already happened or anticipated when the Exchange closes, and the evidence of the financing is there for everyone to see, the taxpayer and the IRS.
It’s more likely to be dealt with because it can’t be hidden.
The taxpayer is less likely to try to get around it.
But with post-Exchange refinancing, the IRS doesn’t know anything about the refinancing because it is not part of the record at the time of the Exchange, and does not become part of the record later.
It is not reported on Form 8824 where the taxpayer reports the Exchange to the IRS.
There is no requirement in Section 1031 for any follow-up reporting by the taxpayer.
So, taxpayers are likely to believe that they can get away with it.
And, of course, there is always someone there to tell them that it is perfectly legal to do it, hoping to sign them up to handle it.
But the rule against a 1031 refinance “in anticipation of an exchange” and “without a legitimate business purpose” applies to post-Exchange just as it does to pre-Exchange.
In Private Letter Ruling 200131014, the IRS gave approval of a refinance of Replacement Property that was to take place “in tax years following the exchange year” because the proceeds of the loan were to be “used exclusively for the taxpayer’s business objectives.”
The implication of the wording in the PLR is that the IRS would not have approved the refinancing in the following tax year if the proceeds were not “used exclusively for the taxpayer’s business objectives.”
In other words, if the refinance had not been in the normal course of the taxpayer’s business, but had only been a way for the taxpayer to get back the net sales proceeds that were reinvested in the Replacement Property, the refinancing would have resulted in taxable boot.
In any event, the IRS maintains their policy on post-Exchange 1031 refinancing, and will likely continue to do so.
And if their budget ever allows them to cross-reference bank loan records with Form 8824 filers, they might have to create additional Courts just to handle the volume.
For more information on how this problem probably originated, look at “How Not To Do A 1031 Refinance” in the Menu.