Investors at times will wonder how to take advantage of all the equity (cash) they have accumulated inside their real estate portfolio. You may also wonder if taking cash out prior to executing a 1031 exchange is prudent. How do you put your equity to good use?
By Al DiNicola, AIF®, CEPA™
October 24, 2023
Adinicola@namcoa.com
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD
There are strategic options on maximizing your equity prior to selling and potentially moving your equity into a more profitable venture. However, like other investment strategies planning and timing are important.
The first leg of the §1031 exchange is the sale of the relinquished property. Investors may wish to take cash out at the time of sale. Any cash taken out at closing is naturally subject to taxation. Refinancing before the exchange or after the exchange becomes the issue. Attempting to refinance the relinquished property prior to sale may be problematic. Once you own the replacement property there appears to be little potential tax issues.
This article is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Each investor’s situation is different, and we encourage you to seek a qualified CPA and tax professional to evaluate your specific needs.
Over the years investors who need cash have turned to cash out refinancing. If you have an investment rental property typically the bank will evaluate your debt service coverage ratio and lending may be based on a percentage of DSCR. The alternative may be to sell your property via a §1031 exchange and then perform the cash out refinancing on the replacement property. Each investor will need to decide which method is preferred based on their individual situation.
1031 Exchange Quick Review
§1031 tax deferred exchange enables the deferral of capital gains when you sell an investment property. There is a strict set of rules that need to be followed. Investors need to reinvest all the cash (equity), purchase equal or greater, replace the debt that may be satisfied, and adhere to timing requirements. For investors not seeking any cash out and simply completing a §1031 the Delaware Statutory Trust (DST) may provide an easy solution for certain accredited investors.
Cash Out Refinance- Quick Review
Cash may be in a real estate property either by the investor paying cash (or having a large deposit when acquired) or because of appreciation of the property. Either way you may be able to extract cash and replace it with a mortgage (or additional mortgage) on the property. In years past the thought was to refinance when interest rates go down. Currently, in 2023, interest rates have risen and while not as attractive as in the past may still be an option for the investor. Especially if the investor has other opportunities with the cash coming out of the refinance.
When the cash comes out of the refinance there is no restriction on what or how you use the cash. The cash also comes tax free. Technically this is regarded as a mortgage and that is why this is not a taxable event. Investors understand that once you place a mortgage on the existing investment the debt service will affect the cash flow on the property.
Motivation and motives on which path to choose are important.
Refinancing Relinquished Property Prior to Closing
Investors who are contemplating entering a §1031 exchange and structure a cash out refinance before the exchange may be placing their exchange in jeopardy. The IRS does not like refinancing prior to an exchange. Here is what the investor is thinking (or planning). The taxpayer already knows he is looking ahead to an upcoming exchange. He may have a high amount of equity accumulated and potentially low (or no) debt. If the exchange is entered into all the cash needs to be reinvested (and replace any debt). If the taxpayer refinances the property pulling cash out (ahead of the exchange) and later sells the property via §1031, the investments will have different replacement metrics. There will be higher debt and lower cash equity. The investor (once the property is sold) would walk away with the debt on the property paid off, cash in his pocket (from the refinancing), higher debt and lower equity in his replacement property and total tax deferral. Yes, this is almost like cheating and why the IRS does not like this arrangement. You may hear the reference to a step transaction (i.e. form over function).
In a §1031 exchange you cannot substitute new debt for cash taken out. (Interesting side bar would be in the case of a §1033 exchange (eminent domain or natural disaster) replacing debt for equity is permitted).
There may be reasons why refinancing happened prior to the exchange. The refinance may be done for other reasons and not in anticipation of the exchange. The more time that elapses between any cash out refinance and the eventual sale of the property (via §1031 exchange) is in the taxpayer’s best interest. What is the right amount of time is a subject for a lot of discussion. There may not be an exact time recommendation. At the very least if it is done somewhat prior to listing the property, even that may be challenged but helpful. However, there are other reasons for the refinancing such as the need for capital improvements like a new roof or property repair. This may be considered an independent business reason. Occasionally an investor may have business cash flow or operating needs for refinancing. If the refinance is not being executed 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. There is always a risk if not planned.
Refinancing Replacement Property After Closing
If there is a straight cash out refinance that does not create a taxable event. What happens if the taxpayer pulls out cash or equity from the replacement property obtained utilizing a §1031 exchange? The IRS does not seem to disallow these post-exchange refinancings. The taxpayer would need to apply for or qualify for the refinancing. Typically the taxpayer must personally guarantee the refinancing (loan).
According to Martin S. Edwards, J.D., CES®- 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.”
Final Thoughts
Eash investor needs to determine what the motivations and motives for the cash out refinance before or after the §1031 exchange. If you are pulling cash out of your investment a year prior to selling the property there may be little challenge from the IRS. DSTs may provide a clear and easy path as a replacement property when executing a 1031. Especially with the debt replacement being a non-recourse loan. However, DSTs will not provide a cash out option after closing.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
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