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1031 Exchange - Refinancing and Step Transaction Doctrine

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.


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