This Tuesday’s Tip is about an often used loophole in the 1031 exchange regulations that has exchangers refinancing their replacement property to tap their equity.
Taxpayers planning to exchange properties under Section 1031 have always been cautioned not to refinance immediately before the sale of the relinquished property. Advice on when you could refinance a 1031 replacement property has varied but many believe one of the greatest loopholes in 1031 is the ability to refinance immediately after the acquisition of the replacement property. This allows exchangers to reinvest all of the net equity of the relinquished property to satisfy the equal or greater equity requirement but still provides the opportunity to tap the equity after the exchange is complete.
Dulles World Property, LLC v. Commissioner (Docket No. 13098-11, Filed August 18, 2011), involved a 1031 exchange transaction. The replacement property was acquired with all cash, however, prior to acquiring the replacement property, the exchanger arranged to refinance the day after the acquisition. The transaction was challenged and IRS said the post-exchange refinancing by the exchanger created taxable "boot." The case against the exchanger was dropped in May 2012 which makes one wonder if IRS didn't want to open that can of worms. Exchangers should always consult their tax advisor when completing a 1031 exchange to plan properly and maximize the tax-deferral opportunities but this could be your way to have your cake and eat it, too.