Refinancing to pull equity out of a property prior to or after completing a tax deferred exchange can result in a taxable transaction under the “step transaction doctrine.” The IRS can argue that a “cash-back” refinance is just one step in many steps that results in not reinvesting all of the equity from the Relinquished Property into Replacement Property.
The only exception is when the refinance is done “in the ordinary course of business” and is not “in anticipation of an exchange.” Otherwise, you should not 1031 refinance either of your properties. The IRS applies the “step-transaction” doctrine and the “substance-over-form” principle to the 1031 refinance. In doing so, the IRS is able to declare that the refinance is part of the Exchange and therefore the same as receiving part of the net sales proceeds as taxable boot.
The biggest issue is whether or not 1031 refinancing is a step-transaction, the substance of which is to take boot out of the exchange without paying tax. In other words, tax avoidance.