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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?”

Exchangers should carefully consider the following issues to avoid the pitfalls of the “step transaction doctrine”:

The refinance loan should not appear to be solely for the purpose of “pulling out equity”, thereby avoiding the capital gain tax that is otherwise attributable to non-exchange transactions.
As a rule of thumb, the refinance transaction should be separated from the exchange sale or purchase transaction to help separate the exchange from the refinance.
At a minimum, the Exchanger should attempt to complete the refinancing transaction prior to listing the relinquished property for sale.
The refinance loan and the sale or purchase in the exchange should be documented as separate transactions to avoid any “interdependence” of the transactions.

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