To defer 100% of taxes in a 1031 exchange a taxpayer must trade “up or equal” in value. For a 1031 exchange to be fully tax deferred, the value, equity and mortgage in the replacement property must be equal to or greater than that of the relinquished property.

If you are trading down in value or equity, you are potentially exposed to taxes to the extent of the trade-down.

You could say that the net proceeds of sale (i.e. the amount held in the exchange account) need to be used in full and the taxpayer needs to put equal or greater debt on the new property compared to the amount paid off at the time of closing on the sale. 

How to access cash while still receiving the benefits of full tax deferral.

During your 1031 exchange

Any cash taken out of the exchange for you, at the closing of your relinquished property (called “cash boot”) will be subject to tax.  This is a common way investors access some funds from their exchange.  

Pre-refinance: refinancing relinquished property prior to closing

A typical property owner, not engaged in a 1031 exchange, can refinance at any time with the cash proceeds received NOT subject to tax. However, as an example, a taxpayer looking ahead to their 1031 exchange might discover high equity and little or no debt in the property to be sold.   The exchange requirements will demand he reinvest all his equity and match mortgage debt at closing.  The taxpayer may wish to finance/refinance that property ahead of his sale and first part of his 1031 exchange.  He could pull cash out with an early refinance and then show up at 1031 exchange closing with lower equity/cash and higher debt/mortgage.   His reinvestment requirements for the replacement part of the exchange are now very different.   

After closing on the sale of his relinquished property, he leaves the first part of the exchange with the debt on the property paid off, cash in his pocket (because of the previous refinance) higher debt and lower equity in his replacement property and total tax deferral.  

However, the IRS has caught on, and doesn’t like it.  They view it as substituting new debt for cash taken out tax free.  Since the taxpayer cannot take out cash on a tax deferred basis at closing during a 1031 exchange, essentially doing the same thing just prior to the closing should be disallowed as well. 

Although we view this pre-refinance as less than ideal, you could provide yourself with a soft landing by keeping some ideas in mind.   One of these is that the refinance was not done with the 1031 exchange in mind.  The more time between the refinance and the 1031 relinquishment the better.  The other idea would be that there is an independent business reason for the refinance.  The business is having cash flow problems, or the property needs a new HVAC system or roof.  

With a pre-refinance done for reasons not related to affecting favorable change to equity and debt ratios a taxpayer should be able to refinance even while contemplating a subsequent 1031 exchange of the property.

Post-refinance: waiting to refinance your replacement property after your closing (and finalized exchange).  The IRS approves.  

A taxpayer need only wait until after closing on the replacement property as the final leg of their forward exchange, before entering a cash out refinance arrangement on that same property. Choosing the side of caution though, you shouldn’t have the cash out refinance done at the same time you are acquiring the property, nor should it be prearranged prior to the purchase of the property. Best practice would be to start the cash out refinance process any time after the replacement property acquisition.

The IRS does not seem to mind post-exchange refinancing. The American Bar Association Section on Taxation explained the logic best: 

In a pre-refinance transaction, the taxpayer is no longer obligated to pay the debt once the loan is paid off at the closing, while still retaining the cash.

In a post-exchange transaction, the taxpayer retains the cash but has an outstanding obligation to repay the debt. 

Cash Out Refinance in 1031 Exchange roundup

A taxpayer might want to generate some cash during the selling of their relinquished at the beginning of a forward exchange.  Cash received by the taxpayer during closing is called “cash boot” and is subject to taxation.  Any equity or debt that is not covered with the purchase transaction will be subject to a variety of taxes mentioned in previous posts (capital gains tax, recapture of depreciation, state taxes and net investment income tax)

Alternatively, the taxpayer may refinance the relinquished property prior to the exchange or refinance the replacement property after the exchange. In the absence of complicating factors, pre-refinancing the relinquished property is usually discouraged, and refinancing the replacement property should not result in any tax issues and should not jeopardize the tax deferral of the exchange.  

The primary reasoning is that with the former, the taxpayer is able to pay off the loan debt at the closing, whereas in the second alternative the taxpayer retains the debt obligation as an offset to the receipt of cash.