Refinancing Before and After Exchanges
Refinancing to pull equity out of a property prior to or after completing a tax deferred exchange
can result in a taxable transaction under the “step transaction doctrine.” The IRS can argue that a
“cash-back” refinancing, immediately before or after the exchange is completed, is just one step in the
many steps of an exchange transaction and, therefore, the refinance loan proceeds should be taxable as
boot in the exchange. This “step transaction” doctrine allows the IRS to recharacterize seemingly separate
transactions into one transaction for tax purposes. The result is an unfortunate outcome for the Exchanger
if the IRS believes that there was no independent business purpose for the refinance loan. In other
words, the threshold question is “was the purpose of the loan nothing more than the Exchanger’s desire to
take cash out of the equity of either the relinquished or replacement properties without paying the capital
gain tax?” Prior to the enactment of the current Treasury Regulations for IRC §1031, the proposed
Regulations in 1990 prohibited “refinancing in anticipation of an exchange.” The final Regulations in 1991,
however, omitted any reference to this refinancing prohibition because the IRS believed that it would
create “substantial uncertainty in the tax results of an exchange transaction involving liabilities.”
Preamble to TD 8343, 56 Fed Reg 14851 (April 12, 1991).
Although there is a mixed case law history on refinancing in conjunction with an exchange, current case
law favors the position that the Exchanger can obtain cash by increasing debt on the property prior to or
after completing an exchange. In Fred L. Fredericks v. Commissioner, TC Memo 1994-27, 67 TCM 2005 (1994),
the Exchanger refinanced the relinquished property two weeks after executing a contract to sell the property
less than a month prior to the resulting exchange. Using the step transaction doctrine, the IRS argued that
the refinance proceeds should be considered taxable boot. The Exchanger prevailed by showing that he had
attempted to refinance the property over a two-year period. In this instance the Court concluded that the
refinance transaction: (a) had an independent business purpose; (b) was not entered into solely for the
purpose of tax avoidance; and (c) had its own economic substance which was not interdependent with the
sale and exchange of the relinquished property.
In Phillip Garcia v. Commissioner, 80 TC 491 (1983), aff’d. 1984-2 CB 1, the seller of a replacement
property increased the debt on the property just prior to exchanging with the Exchanger. The increased
debt was incurred to equalize the liabilities on the replacement property with the liabilities on the
Exchanger’s relinquished property. In this case the IRS took the position that the increase in the mortgage
by the seller should be deemed as boot to the Exchanger because it artificially reallocated the liabilities
for the purpose of avoiding taxes. The Court rejected the IRS’s position finding that the increase in the
debt had “independent economic substance.”
In Behrens v. Commissioner, TC Memo 1985-195, 49 TMC 1284 (1984), the Exchanger was held to have received
taxable boot when he received cash at the closing of his replacement property because he had increased the
amount of the purchase money financing to the seller of the replacement property, thereby reducing the
amount of down payment required from the Exchanger. In the Court’s dicta the Court opined that this adverse
result could have been avoided if the Exchanger had borrowed the cash from a third party lender secured by
the property either before or after the exchange occurred. For further discussion on the factors used by
Courts in determining whether there was an “independent economic substance” of the refinancing, see Letter
Rulings 8248039, 8434015 and 200131014.