Pre-Exchange Refinancing in a 1031 Exchange

Pre-Exchange Refinancing

Recently, a client came to us with a great question about pre/post exchange refinancing. Here's the situation in question:

My husband and I are considering doing a 1031 exchange on our property because of the current hot seller's market in Minneapolis. We own this property free of mortgages. I am now refinancing another rental property and was planning on pulling funds through a new HELOC on this investment property to cover the gap or buy down what we need to refinance the other investment property. If we do this and a month later, put the property on the market to sell and do a 1031 exchange, will that new HELOC cause a problem with the 1031 exchange?  

Avoid Pre-Exchange Refinancing

I would not suggest that you pull the equity of the property just prior to selling it as part of a 1031 exchange. Pre-exchange refinances done in anticipation of exchanges have been challenged by the IRS.

The reason that the IRS does not like pre-exchange refinances is that by pulling the equity out prior to the sale it is equivalent to taking a portion of the sales proceeds at the time of closing, which would be “cash boot” or taxable proceeds.

Most tax commentators prefer post exchange refinancing in a separate, subsequent transaction. The second mortgage should be put in a subsequent post exchange transaction. They may want some space and time between the end of the exchange, and the later refinance.

  • Start Your 1031 Exchange: If you have questions about the 1031 Exchange Process, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.


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