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Refinancing and 1031 Exchanges
A 1031 exchange, also known as a Starker exchange or a tax-deferred exchange, permits investment property owners to sell a property and defer tax payments by reinvesting the proceeds into a "like-kind" investment property or properties. A 1031 exchange is enabled by Section 1031 in the Internal Revenue Code.
To qualify for a 1031 exchange investors are not allowed access to proceeds from the sale of the relinquished property. However, if carefully planned and done with the right “intent”, it is possible to have access to the equity and avoid the IRS deeming the sale a “taxable event”.
Allowable access to the funds can be accomplished by refinancing prior to the sale of the relinquished property or after the purchase of the replacement property.
How the IRS decides when refinancing is appropriate is a gray area. The best guidance can be found by reviewing past IRS decisions. According to case law, the amount of time between the refinance and the sale of the property (the closer the refinance to the close of escrow the higher the chance of the exchange being disallowed) along with the intent of the exchanger and who’s lending the money (family members are not acceptable “lenders”) are key factors indicating the appropriateness of investors’ intent.
Should the IRS choose to audit a refinanced exchange, investors with a good “non tax” reason usually win. When the purpose of the refinance is to avoid payment of taxes or if the refinance appears to be just another “step” in a series of transactions designed to avoid the payment of taxes, investors tend to lose their argument with the IRS.
Justifiable “non tax” reasons for refinancing, either immediately before or after a 1031 Exchange transaction, include:
* A need for cash for documented expansion plans
* Changes in interest rates
* Changes in Investors’ financial condition that would encourage an exchange.
Refinancing the replacement property following the close of escrow is usually met with less scrutiny than refinancing the relinquished property immediately prior to the sale.
An accountant or real estate attorney familiar with 1031 Exchanges should be consulted prior to making any decisions regarding refinancing a property involved in a 1031 Exchange.
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