1031 Exchange FAQ Blog

An interesting concept, this is called anticipatory mortgaging and has some benefits for a 1031 Exchange. What if you were to refinance your Relinquished Property prior to the exchange to get cash and then raise the mortgage to be assumed or paid off by the buyer? Remember these things:

• Borrowing money on your property is not a taxable event so it won’t affect your 1031 Exchange.
• The higher mortgage increases the amount of mortgage boot received that qualifies for offsetting against mortgage boot paid.

Let’s say Davis wants to exchange Cloverleaf Apartments for Sunshine Apartments owned by Roberts. The terms of his exchange include:

• Davis assumes a mortgage of $274,000 on the property he acquires in the exchange.
• Davis has a mortgage on Cloverleaf of  $100,000 that will be assumed by Roberts.
• Based on the market values of the properties, Davis receives cash boot in the amount $200,000 to balance the equities.
• When the exchange is closed, Davis receives taxable boot in the amount of $200,000 making him very unhappy.
  Here’s how his taxable boot is figured following the offset rules of 1031:
  Mortgage on Cloverleaf Property relinquished was $100,000 (mortgage boot received)
  Deduct mortgage on Brentwood assumed by Jones – $274,000 (mortgage boot paid)
  This results in a negative offset – $174,000
• However, under the rules, mortgage offset cannot be less than zero. Davis gets no boot offset from the difference of $174,000 to offset his cash boot received of $200,000. The result is Davis gets hammered for a $200,000 taxable gain.

Experienced 1031 exchangers are quick to recognize transactions where negative boot relief can result in more gain being recognized from net boot received. In our example, Davis should consider borrowing on his Relinquished Property (Cloverleaf) prior to and outside the exchange transaction. If he refinanced and took out $175,000 cash (non-taxable), his boot would be figured like this:

• Davis assumes a mortgage of $274,000 on the property he acquires in the exchange.
• Davis has a mortgage on Cloverleaf of  $275,000 that will be assumed by Roberts.
• To balance the equities, Davis receives cash boot in the amount $25,000.
• When the exchange is closed, Davis receives taxable boot in the amount of only $26,000 making him very happy. Here’s how the taxable boot for this exchange is figured following the offset rules of 1031:
  Mortgage on Cloverleaf Property relinquished was $275,000
  Deduct mortgage on Sunshine assumed by Davis – $274,000
  Difference – Mortgage relief boot received by Davis is $1,000
  Add Cash boot received of $25,000
  Total boot received by Davis is $26,000
  By refinancing outside the exchange, Davis reduces his gain $200,000 to only $26,000.

Exchangers should seriously consider some financing moves outside the exchange to reduce the negative boot relief to zero if possible. Even though equities would not change, the amount of taxable boot could be substantially reduced. This can be accomplished but only with very careful and knowledgeable planning. You don’t want any financing moves treated by the IRS as part of the exchange transaction.

If the refinancing can be demonstrated to be unrelated to the exchange of the Relinquished Property, the proceeds of the refinancing will not be characterized as boot.

The IRS issued a Proposed Regulation making such mortgage proceeds taxable but it was not adopted.

Replacement Property may be refinanced after the exchange is closed and the proceeds used by the owner for any purpose. This is a non-taxable event. However, to qualify, the refinancing must not be connected to the exchange transaction such as a contingency for the exchange to close. The exchange agreement and closing statements should be silent regarding the refinancing.