§1031 Exchange & Cash Out Refinance — Before or After

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.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin- Sher­wood Rd, Suite 200, Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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