A 1031 exchange is just that – an exchange. The IRS wants to see you give up a relinquished property and receive a new replacement property that you don’t already have. Paying down debt on a property that you already own is not seen by the IRS as receiving something new – it’s not an exchange. So that’s not going to work for a 1031 exchange. You need to receive something new and different. Similarly, you want to avoid doing a cash out refinancing before your exchange.
Cash Out Refinancing?
If you run over to the bank in anticipation of your sale and draw out your equity by refinancing the relinquished property, that’s going to look a little suspicious and perhaps trigger some adverse tax consequences.
I generally avoid any refinances in anticipation of an exchange because I don’t want the IRS to come in and say that the refinancing was really the same as if you’d taken the cash at closing.
So generally, I think it’s a bad idea to refinance your relinquished property especially if you have a tacit agreement to sell it or you’re refinancing in anticipation of an upcoming sale.
A Nifty Strategy
Here’s a nifty strategy – reinvest all of your net proceeds from the sale of your relinquished property into new qualifying replacement property. Then later in a subsequent transaction, refinance that replacement property to pull some equity out and use that equity to pay off mortgages on land you already own.
If you’re going to do this you want to pick a replacement property that’s easy to refinance. You don’t want to buy raw land that sits idle and costs you money each year. You probably want to buy an income producing replacement property because that’s easier to go to the bank and lever up.