Tag: 1031 exchange

Most taxpayers who are considering a sell investment real estate in the fourth quarter as part of a 1031 exchange, it is imperative to pay particularly close attention to the exchange deadlines, specifically the rules and regulations around the 180 day exchange period. 
Realize Full Exchange Timeline by Filing for an Extension on Taxes
For example, if you sold your relinquished property after October 17, 2023, you must complete your

Most taxpayers who are considering a sell investment real estate in the fourth quarter as part of a 1031 exchange, it is imperative to pay particularly close attention to the exchange deadlines, specifically the rules and regulations around the 180 day exchange period. 
Realize Full Exchange Timeline by Filing for an Extension on Taxes
For example, if you sold your relinquished property after October 17, 2023, you must complete your

Most taxpayers who are considering a sell investment real estate in the fourth quarter as part of a 1031 exchange, it is imperative to pay particularly close attention to the exchange deadlines, specifically the rules and regulations around the 180 day exchange period. 
Realize Full Exchange Timeline by Filing for an Extension on Taxes
For example, if you sold your relinquished property after October 17, 2023, you must complete your

What is the Same Taxpayer Rule in a 1031 Like-Kind Exchange?
In a 1031 exchange, the taxpayer who owns the relinquished property must be the same taxpayer who takes ownership of the replacement property.  Keep in mind that one of the justifications for tax deferral is that a taxpayer has reported all the incidences of ownership and that the taxpayer’s basis will carry over into the new replacement property.  The taxpayer is only getting deferral, not permanent tax avoidance, and the sheltered gain will be due ultimately upon a future sale of the property without an exchange. If the taxpayer were to change tax identities within an exchange, there would be no continuity of tax ownership and no reason to afford deferral.
In addition, the exchange regulations provide that the taxpayer must transfer the relinquished property as well as receive the transfer of the replacement property.  If, for tax purposes, the taxpayer changes its tax identity between the sale and the purchase, then the same taxpayer will not have disposed of and received property.  So, while the same taxpayer requirement will not be found by those words in the regulations, it is very clearly implicit.
When determining what constitutes “the same taxpayer” the tax identity may be different than the legal title.  It is the tax identity that must be maintained and follow from the relinquished property ownership to the replacement property ownership.  Another way to look at this is whether the selling and buying entities use the same social security number for both properties and does it change to a Federal Tax-Identification Number (FEIN or EIN) from one property to the other. The social security number would typically be used for a single individual’s ownership, including ownership under tax disregarded entities discussed below in more detail. The FEIN number would typically be used for a business or an entity ownership consisting of more than one person or more than one entity, such as a multi-member limited liability company or a partnership.
Can a Taxpayer Change the Ownership but Maintain the Tax Identity?
Remember that we are talking about the tax identity, not necessarily the specific name of the title of the property.  So let’s look at some various ways in which a taxpayer can hold title that would preserve the tax identity:

Hold title in taxpayer’s own name
Hold title under a single member limited liability company (LLC)
Hold title as the trustee of a Revocable Living Trust
Hold title as beneficiary of an Illinois type land trust
Hold title as a Tenant in Common (TIC)
Hold title under a Delaware Statutory Trust (DST)

Holding Title in the Taxpayer’s Own Name
Using the taxpayer’s own name is the most common form or ownership.  This ownership can be as an individual, LLC, partnership, etc.  There is always a tax identification number associated with this ownership. 
Holding Title as a Single Member LLC, Trustee of a Revocable Living Trust, or TIC
Single member LLCs and Self Declarations of Trust (Living Trust) are known as “tax disregarded entities.” These entities are taxed to the party that is the sole member of the LLC or the grantor/beneficiary of the trust.  A TIC is also deemed to be owned by the owner of that Tenant in Common share.  The fact that there are other co-owners of the property has no adverse consequences to the taxpayer being the same taxpayer who sold the property individually.
Holding Title under a Delaware Statutory Trust
DSTs themselves are regarded as a trust, however the owner of a DST share is regarded as owning a beneficial interest in the trust.  As such, a person selling as an individual but buying through a DST interest is still treated as the same taxpayer assuming the beneficial interest is held in the same individual taxpayer’s name.  In 2004,

What is the Same Taxpayer Rule in a 1031 Like-Kind Exchange?
In a 1031 exchange, the taxpayer who owns the relinquished property must be the same taxpayer who takes ownership of the replacement property.  Keep in mind that one of the justifications for tax deferral is that a taxpayer has reported all the incidences of ownership and that the taxpayer’s basis will carry over into the new replacement property.  The taxpayer is only getting deferral, not permanent tax avoidance, and the sheltered gain will be due ultimately upon a future sale of the property without an exchange. If the taxpayer were to change tax identities within an exchange, there would be no continuity of tax ownership and no reason to afford deferral.
In addition, the exchange regulations provide that the taxpayer must transfer the relinquished property as well as receive the transfer of the replacement property.  If, for tax purposes, the taxpayer changes its tax identity between the sale and the purchase, then the same taxpayer will not have disposed of and received property.  So, while the same taxpayer requirement will not be found by those words in the regulations, it is very clearly implicit.
When determining what constitutes “the same taxpayer” the tax identity may be different than the legal title.  It is the tax identity that must be maintained and follow from the relinquished property ownership to the replacement property ownership.  Another way to look at this is whether the selling and buying entities use the same social security number for both properties and does it change to a Federal Tax-Identification Number (FEIN or EIN) from one property to the other. The social security number would typically be used for a single individual’s ownership, including ownership under tax disregarded entities discussed below in more detail. The FEIN number would typically be used for a business or an entity ownership consisting of more than one person or more than one entity, such as a multi-member limited liability company or a partnership.
Can a Taxpayer Change the Ownership but Maintain the Tax Identity?
Remember that we are talking about the tax identity, not necessarily the specific name of the title of the property.  So let’s look at some various ways in which a taxpayer can hold title that would preserve the tax identity:

Hold title in taxpayer’s own name
Hold title under a single member limited liability company (LLC)
Hold title as the trustee of a Revocable Living Trust
Hold title as beneficiary of an Illinois type land trust
Hold title as a Tenant in Common (TIC)
Hold title under a Delaware Statutory Trust (DST)

Holding Title in the Taxpayer’s Own Name
Using the taxpayer’s own name is the most common form or ownership.  This ownership can be as an individual, LLC, partnership, etc.  There is always a tax identification number associated with this ownership. 
Holding Title as a Single Member LLC, Trustee of a Revocable Living Trust, or TIC
Single member LLCs and Self Declarations of Trust (Living Trust) are known as “tax disregarded entities.” These entities are taxed to the party that is the sole member of the LLC or the grantor/beneficiary of the trust.  A TIC is also deemed to be owned by the owner of that Tenant in Common share.  The fact that there are other co-owners of the property has no adverse consequences to the taxpayer being the same taxpayer who sold the property individually.
Holding Title under a Delaware Statutory Trust
DSTs themselves are regarded as a trust, however the owner of a DST share is regarded as owning a beneficial interest in the trust.  As such, a person selling as an individual but buying through a DST interest is still treated as the same taxpayer assuming the beneficial interest is held in the same individual taxpayer’s name.  In 2004,

What is the Same Taxpayer Rule in a 1031 Like-Kind Exchange?
In a 1031 exchange, the taxpayer who owns the relinquished property must be the same taxpayer who takes ownership of the replacement property.  Keep in mind that one of the justifications for tax deferral is that a taxpayer has reported all the incidences of ownership and that the taxpayer’s basis will carry over into the new replacement property.  The taxpayer is only getting deferral, not permanent tax avoidance, and the sheltered gain will be due ultimately upon a future sale of the property without an exchange. If the taxpayer were to change tax identities within an exchange, there would be no continuity of tax ownership and no reason to afford deferral.
In addition, the exchange regulations provide that the taxpayer must transfer the relinquished property as well as receive the transfer of the replacement property.  If, for tax purposes, the taxpayer changes its tax identity between the sale and the purchase, then the same taxpayer will not have disposed of and received property.  So, while the same taxpayer requirement will not be found by those words in the regulations, it is very clearly implicit.
When determining what constitutes “the same taxpayer” the tax identity may be different than the legal title.  It is the tax identity that must be maintained and follow from the relinquished property ownership to the replacement property ownership.  Another way to look at this is whether the selling and buying entities use the same social security number for both properties and does it change to a Federal Tax-Identification Number (FEIN or EIN) from one property to the other. The social security number would typically be used for a single individual’s ownership, including ownership under tax disregarded entities discussed below in more detail. The FEIN number would typically be used for a business or an entity ownership consisting of more than one person or more than one entity, such as a multi-member limited liability company or a partnership.
Can a Taxpayer Change the Ownership but Maintain the Tax Identity?
Remember that we are talking about the tax identity, not necessarily the specific name of the title of the property.  So let’s look at some various ways in which a taxpayer can hold title that would preserve the tax identity:

Hold title in taxpayer’s own name
Hold title under a single member limited liability company (LLC)
Hold title as the trustee of a Revocable Living Trust
Hold title as beneficiary of an Illinois type land trust
Hold title as a Tenant in Common (TIC)
Hold title under a Delaware Statutory Trust (DST)

Holding Title in the Taxpayer’s Own Name
Using the taxpayer’s own name is the most common form or ownership.  This ownership can be as an individual, LLC, partnership, etc.  There is always a tax identification number associated with this ownership. 
Holding Title as a Single Member LLC, Trustee of a Revocable Living Trust, or TIC
Single member LLCs and Self Declarations of Trust (Living Trust) are known as “tax disregarded entities.” These entities are taxed to the party that is the sole member of the LLC or the grantor/beneficiary of the trust.  A TIC is also deemed to be owned by the owner of that Tenant in Common share.  The fact that there are other co-owners of the property has no adverse consequences to the taxpayer being the same taxpayer who sold the property individually.
Holding Title under a Delaware Statutory Trust
DSTs themselves are regarded as a trust, however the owner of a DST share is regarded as owning a beneficial interest in the trust.  As such, a person selling as an individual but buying through a DST interest is still treated as the same taxpayer assuming the beneficial interest is held in the same individual taxpayer’s name.  In 2004,

Can a partner or member trade their share of a property interest upon sale?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself.  The section generally provides
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.”  As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members. 
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share.  The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
How is a 1031 drop and swap done?
A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position.  If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
IRS Form 1065 U.S. Return of Partnership Income
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.”  Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis. 
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange.  Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
Underlying Loan Considerations
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member.  As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member.  In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses.  So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents.  This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
Deemed Partnership
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership.  This would negate a drop and swap.  Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs.  The least amount of management by the co-owners is helpful to avoid partnership characterization.  Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property. 
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship.  The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership.   It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible.  Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
Summary
The possibility of structuring of a

Can a partner or member trade their share of a property interest upon sale?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself.  The section generally provides
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.”  As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members. 
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share.  The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
How is a 1031 drop and swap done?
A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position.  If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
IRS Form 1065 U.S. Return of Partnership Income
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.”  Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis. 
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange.  Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
Underlying Loan Considerations
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member.  As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member.  In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses.  So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents.  This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
Deemed Partnership
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership.  This would negate a drop and swap.  Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs.  The least amount of management by the co-owners is helpful to avoid partnership characterization.  Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property. 
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship.  The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership.   It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible.  Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
Summary
The possibility of structuring of a

Can a partner or member trade their share of a property interest upon sale?
One of the most common questions asked of a qualified intermediary involves the situation in which one or more members or partners in a limited liability company (LLC) or partnership wish to do a 1031 exchange and others simply wish to cash out. There are several practical difficulties in this regard starting with Section 1031 itself.  The section generally provides
“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged for property of like kind which is held for productive use in trade or business or for investment”.
However the section also provides for several exclusions to the ability to trade any qualified use asset and one of those exclusions states “This subsection shall not apply to any exchange of interests in a partnership.”  As a result, the challenge here is to allow members to go their separate ways while not deeming them attempting to trade in their capacities as members. 
While there are multiple ways to structure transactions allowing various members to effectively trade their interest, by far the most common technique is for the outgoing member to have the LLC redeem the member’s interest and to convey by deed the applicable percentage interest in the property equivalent to the member’s former share.  The transfer to the member and the subsequent trade by that person is generally referred to as a “drop and swap.”
How is a 1031 drop and swap done?
A 1031 like kind exchange rules, a taxpayer’s holding period and use of property should include the holding period of and use of the property by the transferor, in the case of property….distributed by a partnership to a partner…”
To date the IRS has not adopted this position.  If anything, over time the drop and swap appears to be increasingly disfavored by the IRS.
IRS Form 1065 U.S. Return of Partnership Income
In 2008, as part of the IRS’ attempt to limit drop and swap transactions, Schedule B 14 was added to http://www.irs.gov/pub/irs-pdf/f1065.pdf”>Form 1065. Schedule B 14 asks “At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property.”  Prior to the inclusion of this check-the-box requirement, drop and swaps were frequently done on a “don’t ask, don’t tell” basis. 
As a result of this reporting requirement, it is far better, when planning on a member exchange, to distribute out to the member(s) in a tax year prior to the year in which the sale of the property takes place. This enhances the holding period requirement and separates the drop to a prior tax year from the year in which the former member is completing an exchange.  Most Section 1031 experts also strongly suggest making any of these changes prior to entering into a contract for sale.
Underlying Loan Considerations
When a deed of conveyance to a fractional interest in the real estate is given to the outgoing member, that deed is subject to whatever debt is on the property, however the debt is an obligation of the LLC and not that of the member.  As a result, the conveyance does not, by itself, act to transfer a pro-rata amount of debt to that member.  In order to avoid all the debt remaining against the LLC, the Operating Agreement or the Partnership Agreement needs to be amended to allow for a special debt allocation to flow through to the member as part of his receiving a deed to the fractional interest.
Almost all loans secured by property contain “due on transfer” clauses.  So conveying an interest in the property to one or more members may constitute a technical violation under the loan documents.  This is often overlooked since the loan payments are kept current and the property would likely be sold before a lender took notice of any transfer.
Deemed Partnership
There is a long history of case law in which the IRS has successfully argued that if a TIC holding has the attributes of a partnership, the co-ownership relationship will be deemed a partnership.  This would negate a drop and swap.  Although there are many factors that go into determining whether a co-ownership constitutes a de facto partnership, the single largest factor is the degree in which the property is managed by the TICs.  The least amount of management by the co-owners is helpful to avoid partnership characterization.  Often in an attempt to deal with this consideration, the co-owners will appoint a single co-owner as management agent for the group or will have an outside management company manage the property. 
For other various reasons, co-ownership groups will sometimes enter into a tenant in common agreement setting forth their respective rights and relationship.  The terms of such an agreement comes from IRS guidance in the form of http://www.irs.gov/pub/irs-drop/rp-02-22.pdf”>Rev. Proc. 2002-22. These agreements are often used by lawyers advising clients in order to rebut the argument of a deemed partnership.   It is generally understood in the legal community that it is almost impossible for a co-ownership structure to adhere to each and every requirement set forth in the Rev. Proc., but many people try to pattern a tenant in common arrangement to include as many of the provisions as possible.  Caution should be taken to avoid the situation where a TIC agreement is entered into, but its terms are ignored in whole or in part by the co-owners.
Summary
The possibility of structuring of a

Most taxpayers wish to defer tax in full when completing a 1031 exchange.  In order to accomplish this, one simple rule of thumb is that the taxpayer must trade “up or equal” in value.  Perhaps a better way to look at this is to make sure the net proceeds of sale (i.e. the amount held in the exchange account) are used in full and the taxpayer puts on equal or greater debt on the new property compared to the amount paid off at the time of closing on the sale.  Another expression sometimes used is that the taxpayer should have “no net debt relief.”  Any cash taken out at closing and any debt that is not covered could be subject to:

Capital gains tax
Recapture of depreciation
State taxes
Net Investment Income Tax (also known as Affordable Care Act tax)

Oftentimes with exchange transactions, taxpayers wish to receive some cash out for various reasons.  Any cash generated at the time of the sale that is not reinvested is referred to as “boot” and the amount is taxable.  There are a couple of possible ways to gain access to that cash while still receiving full tax deferral.
Refinancing Relinquished Property Prior to Closing
For an owner of real estate, not engaging in a 1031 exchange, who wishes to refinance it at any time, any cash proceeds received are not subject to tax. However, in many cases, a taxpayer looking ahead to an upcoming exchange of his property may find himself with a high amount of equity and relatively low (or no) debt, this will require him to reinvest all the cash (and match debt).  The taxpayer may wish to finance or refinance the property pulling cash out and later go to closing with higher debt and lower cash equity, as a result his reinvestment requirements for the replacement exchange property are suddenly very different.  Essentially he walks away from the transaction with the debt on the property paid off, cash in his pocket, higher debt and lower equity in his replacement property and total tax referral The problem with this approach is that the IRS does not like it.  It is almost like cheating.  Essentially it is substituting new debt for cash taken out.  Since the taxpayer cannot take out cash on a tax deferred basis at closing, essentially doing the same thing just prior to the closing should be disallowed as well. The IRS does not look favorably upon a step transaction, which basically means that if something is not allowed to be done in a direct fashion (taking out cash at closing), by taking a few additional steps to avoid the application of the rule, is not allowed either. 
There are a couple of facts which may improve the IRS position on these refinance transactions.  One of these is the impression that the refinance is not done in anticipation of the exchange of the property.  In general, the more time that elapses between any cash out refinance and the eventual sale of the property is in the taxpayer’s best interest  There is no bright line safe harbor for this, but at the very least if it is done somewhat prior to listing the property, that fact would be helpful.  The other consideration that comes up a lot in IRS cases is the presence of independent business reasons for the refinance.  Maybe the taxpayer’s business is having cash flow problems.  Maybe the property needs a new roof, etc.  To the extent that the refinance is done for other reasons and not solely to effect a favorable change to the debt and equity numbers, a taxpayer should be able to refinance even while contemplating a subsequent 1031 exchange of the property.
Refinancing Replacement Property After Closing
As was stated above, in the absence of any exchange transaction, a taxpayer who chooses to do a cash out refinance does not trigger any tax.  The question then is whether that principle applies to refinancing to pull equity out after the acquisition of the replacement property is complete.  Is that taxpayer in any different position from one who is doing a cash out refinance for property held but not part of an exchange transaction?  Probably not and accordingly, the IRS does not seem to disallow these post-exchange refinancings.  The American Bar Association Section on Taxation addressed these issues, and others, as part of an open report it prepared after the exchange rules came out.  The committee concluded that in the case of pre-exchange refinance the taxpayer is no longer obligated to pay the debt once the loan is paid off at the closing, while still retaining the cash.  In a post-exchange transaction, the taxpayer retains the cash but has an outstanding obligation to repay the debt.  The committee concluded:

“The key to the distinction between pre-and post-exchange refinancings is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for pre-exchange relinquished property refinancing upon transfer of the relinquished property.  A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth.”

Consistent with this reasoning, one noted author used the term “nanosecond” to indicate how long a taxpayer needs to wait before entering into a cash out refinance on the replacement property.  In other words, once a taxpayer owns the replacement property and refinances it incurring a repayment obligation, that taxpayer is in no different position than anyone else owning property and refinancing it.  Most authors take a similar position, but caution not to have the cash out refinance done concurrently with the acquisition of the property nor to have it prearranged prior to the purchase of the property.  Best practice would be to start the cash out refinance process any time after the replacement property acquisition.
Summary of Cash Out Refinance in 1031 Exchange
Taxpayers sometimes wish to generate some cash on or around the time of selling relinquished property as the first leg of an exchange.  Any sums paid to the taxpayer at closing are subject to taxation.  As an alternative, a taxpayer may wish to refinance the relinquished property before the exchange or refinance the replacement property after the exchange.  In the absence of mitigating factors, refinancing the relinquished property is generally discouraged, however  refinancing the replacement property should not result in any tax issues and should not jeopardize the tax deferral on the transaction.  The primary logic for these positions is that with the former, the taxpayer is able to pay off the loan debt at the closing, whereas in the second alternative the taxpayer retains the debt obligation as an offset to the receipt of cash.

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Updated 3/21/2022.