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Real Estate Journal — October 24 - November 13, 2014 — 15A
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M id A tlantic R eal E state J ournal “Key Cases And Private Letter Rulings” Part 1 Refinancing Relinquished Property Pre- Exchange&ReplacementPropertyPostExchange
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n the Northeast, many sell- ers are considering the sale of appreciated investment
tax purposes or combined into a single integrated transaction for tax purposes. Since a cash- out refinancing in anticipation of a tax deferred exchange will usually be paid off on the sale of the relinquished property, it may be difficult to establish that financing had an indepen- dent purpose apart from the tax result. Note too that financing on the relinquished property at closing alters the amount of equity required to be reinvested In replacement property to achieve 100% deferral of all capital gain taxes. Although the IRS has not always won these cases (in fact, it often
loses), the principles described in the following cases should be considered when a taxpayer assesses the risks associated with a cash out refinancing in anticipation of a tax deferred exchange. In Fredericks v. Commis- sioner, T.C. Memo 1994-27, the taxpayer’s cash out refinanc- ing was not treated as boot because the refinancing was (i) independent of the 1031 exchange (ii) not conditioned on the closing (iii) dependent on the creditworthiness of the taxpayer and (iv) made suffi- ciently in advance of the 1031 continued on page 16A
property due to the rise in real estate values and to defer the sub- stantial capi- tal gain taxes that would be incurred on the sale by
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performing a Section 1031 exchange. Many of the sellers have no or little mortgage debt on the relinquished property and would like to increase that debt to maximize their returns and possibly to use the cash from the refinancing for activi- ties unrelated to the property. As with many tax matters, caution is recommended and timing can be everything. Under Section 1031, cash or other non-like kind property actually or constructively re- ceived by the taxpayer in a tax deferred exchange (commonly referred to as “boot”) causes the taxpayer to recognize gain to the extent of such boot. In some cases, taxpayers seek to avoid taking boot on the sale of relinquished property by borrowing against the relin- quished property shortly before the exchange. Ordinarily, a taxpayer’s receipt of loan pro- ceeds is not taxable, but if the taxpayer borrows against the relinquished property in a cash- out refinance shortly before an exchange rather than simply taking sale proceeds on the sale of the relinquished property and re-investing such proceeds, does the taxpayer avoid recog- nition of gain? Maybe. Since the only significant difference between taking boot on the sale of relinquished property and borrowing against the same property before the exchange is the tax result (in each case, the taxpayer pockets the cash received), the Internal Revenue Service (IRS) has asserted the “step transac- tion doctrine” in an attempt to combine the pre-exchange borrowing with the exchange in cases where it determines that tax avoidance was the taxpayer’s principal motiva- tion. The basic idea behind the step transaction is that the tax results of a series of steps in a transaction should be de- termined based on the overall result of a transaction if those steps are interrelated. Thus, the key issue is whether two or more transactions should be viewed as separate steps for
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