FEATURE ARTICLE, JUNE 2008

REFINANCING CONCERNS AND SECTION 1031
Taking measures before the qualified intermediary comes in may save your client money.
Alan Hall

Hall

A taxpayer should make every effort to avoid refinancing close in time to the date of an exchange because the IRS may view any recent re-adjustment of debt as a tax avoidance mechanism and treat any loan proceeds received by the taxpayer as taxable. In other words, any new loan could be viewed as an artificial attempt to reallocate liabilities for the purpose of tax avoidance.

For example, a taxpayer anticipating receipt of $150,000 in proceeds might want to only reinvest $100,000 into replacement property. The $50,000 that he does not wish to reinvest will be taxed at the applicable capital gains rate. However, in many cases, a refinance loan arranged just prior to the exchange might be used to attempt to avoid this taxable result — such as, just before exchanging, the taxpayer increases an existing loan balance by $50,000, keeps the $50,000 cash and proceeds with the exchange, thereby reducing any anticipated cash proceeds. This re-adjustment of existing debt would be deemed an impermissible tax avoidance mechanism.

Likewise, if a loan is refinanced just after replacement property is acquired or during the exchange transaction, the same result may occur. For example, a taxpayer who exchanges into replacement property with a loan of $100,000 (as required by the equities on the property he exchanged out of) shortly thereafter increases that new loan to $125,000 to obtain $25,000 cash. The result is what the taxpayer intended — $25,000 cash in his pocket and a higher loan amount, but again, not what the IRS may allow. The IRS may treat this as equivalent to a taxpayer failing to invest all of his net cash proceeds in the replacement property and instead obtaining a higher loan amount to put cash in his pocket.

If avoiding the refinance is not possible, with careful planning, a taxpayer may structure the refinance to minimize the risk of a potential unfavorable tax consequence.

Careful Planning Tips

A taxpayer refinancing close in time to an exchange should consider the following criteria in structuring the loan transaction.

(1) Avoid integrating the refinance transaction with the exchange transaction.

i. Complete any pre-exchange refinance as far in advance as possible of the exchange — preferably before listing the property or entering into any agreement related to the sale/exchange of the property.

ii. Any post-exchange refinance should be a completely separate transaction from the exchange. Make sure that no agreements related to or in anticipation of the refinance are entered into or negotiated during the pendency of the exchange.

(2) When the refinance is close in time to the exchange, scrutinize the documents and the transaction as a whole to make sure that the form accurately reflects the substance of the transaction.

(3) Make sure the loan has an economic significance independent of the exchange (lower interest rate, more favorable terms and/or pre-existing need to refinance, for example).

(4) Never use refinancing to reallocate existing liabilities for the sole purpose of tax avoidance.

What do I have to know as an agent?

What is the role of the real estate agent in all of this? While you may choose to rely solely upon the safe haven of experienced qualified intermediary (QI) to help your client through the tangled web of rules and regulations of an exchange, such reliance, with little involvement by you, may prove dangerously expensive to your reputation and your client’s pocketbook. Arming yourself with information about the exchange process will help you avoid common pitfalls. One such pitfall that is easily avoided is compliance with the IRS requirement that the purchase and sale contract — whether it be for a client’s relinquished property or replacement property — be assigned to the QI and that the other party receives written notice of the assignment. Your client’s QI will supply the appropriate contract language and assignment notice; you need to know to ask for it.

The IRS reiterated this requirement in its Private Letter Ruling 200130001, wherein the taxpayers had to pay the tax on their gain from the sale of two properties simply because no notice of the assignment to their exchange intermediary was ever given to the purchasers of their relinquished properties. The result seems harsh; nonetheless, compliance is relatively simple.

It is important to know that absent written notice of an assignment to the exchange intermediary, taxpayers will be treated as if they transferred the property directly to the purchasers with no involvement of a QI. Specifically, section 1.1031(k)-1(g)(4)(v) of the Treasury Regulations governing exchanges provides that QI is treated as entering into an agreement if the rights of a party to the agreement are assigned to the QI and all parties to that agreement are notified in writing of the assignment on or before the transfer of the property.

Prevent this scenario from happening to your client by taking the following simple steps:

First, if your clients are selling non-owner occupied property, you should inquire about whether they intend to do an exchange. Once, your clients indicate their intention to participate in an exchange, inform the other parties to the contract about the exchange so that they can anticipate the few simple things they need to do in the transaction. To alleviate any fears from the other side about the extent and nature of their involvement, you may want to explain that a simple assignment of the contract to your clients’ QI will take place and that the assignment is critical to the proper documentation of the exchange. You also should let the party know that substantively, your clients remain the real party in interest with whom they or their agent will be dealing and that their rights to enforce any provisions of the contract remain unaffected by the assignment.

Second, put a simple clause in the contract whereby the other party agrees to cooperate in the exchange. This language may be included by way of an addendum to the contract. The agreement to cooperate is very important because it notifies the other side of the exchange and — more importantly — helps protect against the possibility of that party later refusing to acknowledge the assignment of the contract in writing. Many of the form contracts contain this language. If not, the QI can provide the appropriate contract language.

Third, keep in touch with your clients’ QI and make sure they have sent written notice of the assignment to the other side; and that they have also obtained — before transfer of the property — a written acknowledgement of the assignment from the other side. This acknowledgement often will be in the form of a consent to the assignment executed by the other party in the closing.

In short, certain measures taken by you before the QI enters the picture not only will impress your clients, but may save them the expense of an unfortunate pitfall in the IRC 1031 exchange.

Alan Hall is the regional manager for OREXCO 1031 Exchange for Texas, Oklahoma and New Mexico.
* Old Republic Exchange Facilitator Company (OREXCO) does not give tax or legal advice. Please consult with your tax advisor to determine whether an exchange is appropriate for you.

©2008 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.