Although there is a mixed case law history on refinancing in conjunction
with an exchange, current case law favors the position
that the Exchanger can obtain cash by increasing debt on the
property prior to or after completing an exchange.
In Fred L. Fredericks v. Commissioner, TC Memo 1994-27, 67
TCM 2005 (1994), the Exchanger refinanced the relinquished
property two weeks after executing a contract to sell the property
less than a month prior to the resulting exchange. Using the step
transaction doctrine, the IRS argued that the refinance proceeds
should be considered taxable boot. The Exchanger prevailed by
showing that he had attempted to refinance the property over a
two-year period. In this instance, the Court concluded that the
refinance transaction: (a) had an independent business purpose;
(b) was not entered into solely for the purpose of tax avoidance;
and (c) had its own economic substance which was not interdependent
with the sale and exchange of the relinquished property.
In Phillip Garcia v. Commissioner, 80 TC 491 (1983), aff’d. 1984
-2 CB 1, the seller of a replacement property increased the debt on
the property just prior to exchanging with the Exchanger. The
increased debt was incurred to equalize the liabilities on the replacement
property with the liabilities on the Exchanger’s relinquished
property. In this case, the IRS took the position that the
increase in the mortgage by the seller should be deemed as boot to
the Exchanger because it artificially reallocated the liabilities for
the purpose of avoiding taxes. The Court rejected the IRS’s position,
finding that the increase in the debt had independent economic
In Behrens v. Commissioner, TC Memo 1985-195, 49 TMC 1284
(1984), the Exchanger was held to have received taxable boot when
he received cash at the closing of his replacement property because
he had increased the amount of the purchase money financing to the
seller of the replacement property, thereby reducing the amount of
down payment required from the Exchanger. In the Court’s dicta, the
Court opined that this adverse result could have been avoided if the
Exchanger had borrowed the cash from a third party lender secured
by the property either before or after the exchange occurred. For further
discussion on the factors used by Courts in determining whether
there was an independent economic substance of the refinancing, see
Letter Rulings 8248039, 8434015 and 200131014.
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.