HELOC Drawn Before the Sale: Boot, Debt Relief and What to Do Now

Every lien paid off at closing counts toward the debt you must replace

Treas. Reg. section 1.1031(d)-2 treats "the amount of any liabilities of the taxpayer assumed by the other party to the exchange (or of any liabilities to which the property exchanged by the taxpayer is subject)" as money received. A HELOC recorded against the property is one of those liabilities, whatever its balance or how recently you drew it.

That includes a line you drew years ago for repairs and one you drew last month. The regulation looks at what the property is subject to when it is transferred, so the payoff letters, not your memory of the balance, set the figure.

So the number to replace is the total payoff on the closing statement, not the first mortgage alone. The Form 8824 instructions compute boot from net liabilities: debt taken over or paid off, less liabilities you assume, cash you pay and other property you give up.

A personal line of credit that is not secured by the property is different: it is not paid off from the sale and is not relieved by it. Using exchange funds to pay it would be cash to you; see paying off a HELOC or other debts with exchange funds.

Worked example: a $200,000 draw two months before listing

Hypothetical, round numbers, ignoring closing costs. Your rental is worth $1,000,000 with a $300,000 first mortgage. You draw $200,000 on a HELOC secured by it, then sell for $1,000,000. The closing pays off $500,000 and sends $500,000 to the qualified intermediary. Run your own numbers with your CPA.

• Replacement at $1,000,000 with a $300,000 loan and $500,000 of exchange equity: $200,000 short, so $200,000 of debt relief is taxable unless you add $200,000.
• Same purchase, adding the $200,000 you drew as your own cash: debt relief is offset, nothing is taxed, and the drawn cash is back in real estate.
• Same purchase with a $500,000 loan and no cash added: the netting rules show no boot, and you keep the $200,000. This is the version an examiner may question if the draw was tied to the sale.

Why a draw timed to the sale is the risky version

Borrowing is not income, and the regulations net liabilities without asking when they were incurred. The risk comes from substance-over-form principles. In Commissioner v. Court Holding Co., 324 U.S. 331 (1945), the Supreme Court said "the incidence of taxation depends upon the substance of a transaction" and that "the transaction must be viewed as a whole, and each step" is relevant.

Applied here, if the draw and the sale were steps in one plan to take cash out, the IRS can argue that you received $200,000 of the sale price, which section 1031(b) taxes to the extent of gain. The regulations give no rule for how far apart the steps must be.

Because the question is what the steps were for, keep a written record of when you drew the line, why, and where the money went. A draw after the property was listed or under contract, with the cash still in your account at closing, is the pattern most exposed to the argument, and putting that cash back in at the replacement closing removes it.

Refinance timing around a 1031 covers planning a refinance before or after an exchange; this page is about fixing one already done.

What to do now: a five-step clean-up before the replacement closes

If the sale has not closed, you still have the most options. If it has, the steps below still apply until the replacement closes.

• Get payoff letters for every lien and confirm the total that will be, or was, paid at closing.
• Write down when and why you drew the HELOC, and where the money went; your CPA needs this if the timing is questioned.
• If the cash is unspent, plan to bring it to the replacement closing as added cash, which offsets debt relief dollar for dollar under the Form 8824 netting.
• Size the new loan and added cash so together they at least equal the full payoff; the exchange equation shows the test.
• Do not use exchange funds to pay any HELOC or loan on another property; that is not a routine closing item and is treated as cash to you.

If you cannot borrow enough on the replacement, a high-leverage DST can carry the gap

A larger payoff means more debt to replace, and a new lender may not lend that much. Our cash out DST is designed to solve debt requirements with a small portion of the proceeds: all operating income services the non-recourse loan, there are no current distributions, and the payout comes on sale. It is illiquid and leveraged, and it must be identified by day 45. When the new lender wants more down works through the split.

If what you really want is cash out of the property, compare a cash-out refinance vs a 1031 and pulling cash out after a 1031, which put the borrowing on the replacement after the exchange instead of before it.