Many investors take advantage of 1031 exchanges due to how this strategy allows tax deferral and diversification of assets. The process allows the swap of two like-kind properties with no sale occurring, so there’s no taxable event. To prevent abuse, however, the IRS has set many strict rules for the 1031 exchange. One core tenet is the requirement to reinvest all the proceeds from the sale of the relinquished property into the replacement one to receive complete tax deferral.
This requirement limits how you can handle your capital. As such, many investors have wondered if strategies like refinancing are allowable so they can access some of their equity. This practice is possible, but it takes an in-depth understanding of the like-kind exchange to prevent any taxable events or IRS scrutiny. In this blog post, Realized 1031 explores the 1031 exchange cash-out refinance process to help you understand how it works.
In theory, you can take out some of the proceeds from the exchange even before it’s completed. However, you will incur boot. which is is taxable. This conundrum led investors to try strategies like refinancing.
Refinancing is the process of replacing an existing mortgage with a new one, typically with improved loan terms such as a lower interest rate or extended repayment period. Many investors use refinancing to reduce their debt burden, improve cash flow, or access equity tied up in the property.
A more specific type of refinancing is called cash-out refinancing. In this case, you take out a new mortgage that is higher than the existing loan balance. You then receive the difference in cash. Thanks to this strategy, you can unlock some equity without having to sell the property. This is the most common approach for investors who want liquid cash.
However, the timing of a cash-out refinance is critical for those undergoing a 1031 exchange to avoid tax consequences. More specifically, you can only conduct a cash-out refinance before or after the swap. As we mentioned above, you’re not allowed to have direct control of the proceeds during the sale, and taking out any cash — even through a new loan structure — will result in a taxable event.
Refinancing 1031 exchanges may be advantageous for investors who need extra resources for the following.
Refinancing in connection with a 1031 exchange involves complex tax and legal considerations and should be approached with caution. Due to the potential for IRS scrutiny and other associated risks, this strategy is typically most appropriate when supported by thorough planning and guidance from qualified tax and legal professionals.”
In a 1031 exchange, taxpayers must generally acquire a replacement property of equal or greater value than the relinquished property to fully defer capital gains taxes. This principal carries over to debt. You must also purchase a property that has equal or greater debt (mortgage) than the one you just sold. Failure to do so may result in “boot,” which is subject to taxation.
Given this, the loan-to-value ratio (LTV) becomes a relevant metric that measures the risk the lender takes before approving a mortgage. In the context of real estate, LTV would be the mortgage amount divided by the value. Most lenders require an LTV of 75–80% for a cash-out refinance, meaning investors can access up to 75–80% of their property’s value while maintaining equity in the asset. Knowing this number allows you to plan how much you can borrow against your property while still complying with 1031 exchange rules. However, LTV metrics alone do not determine 1031 compliance, and refinancing activity should be evaluated carefully in coordination with tax and legal advisors.
Since you cannot access the proceeds during the exchange, you refinance either before or after the transaction. Refinancing before beginning the exchange provides a few advantages, such as having the cash available upfront for potential improvements or other investment opportunities related to the new property. However, the IRS closely scrutinizes refinancing before exchange because this could mean that you’re just using the swap as merely a means for capital preservation — a step transaction.
If the service does prove that you’re just refinancing to pull cash out before the exchange, then the withdrawn funds may be considered as boot. As we mentioned above, boot is taxable. The transaction will only be a partially deferred exchange, and you will have tax liability when filing season comes.
Given these risks, timing matters in such a strategy. Refinancing too close to an exchange (such as within a few months before selling) raises red flags. The IRS may view this as an attempt to avoid taxes rather than a legitimate business move.
Another way to lower scrutiny is by justifying the refinancing as a necessary strategy for business purposes. Investors should document a valid reason for refinancing, such as securing a better interest rate or restructuring debt, rather than simply extracting equity for personal use.
Once you’ve done these preliminary steps, here’s how to go about with the refinancing.
The other option is to refinance after the exchange. Generally, this strategy is much safer than refinancing before the swap, at least, from a tax perspective. After you finalize and close the acquisition, you can explore cash-out refinancing options without jeopardizing their tax-deferred status. There are still risks, and you will still need to follow IRS rules to maintain your tax benefits.
To refinance after the exchange, here are some key steps to follow.
Refinancing a 1031 exchange to access equity is inherently risky. Knowing the possible tax consequences can help you avoid the scenarios that lead to these liabilities. Here are some potential tax triggers you’ll want to avoid.
If an investor refinances before selling and extracts cash, the IRS may consider this boot, making the withdrawn amount subject to capital gains tax. As such, refinancing well ahead of the exchange is key if you’re going to take this route before the swap.
Another scenario that may trigger a taxable event is if the new loan for the replacement property is lower than the loan for the relinquished asset. Given the debt replacement rule, the difference may be considered as capital gains and will be taxable.
As we mentioned above, the IRS could view a refinance that occurs too soon before or after an exchange as part of a larger scheme to extract equity while avoiding taxes. This could result in a challenge to the tax-deferred status of the exchange. Should the IRS prove your intention, you may lose your tax benefits altogether.
With the high potential for scrutiny and significant tax implications, 1031 exchange cash-out refinances must be done with care and deliberation. Our most important recommendation is to engage with tax professionals or 1031 experts like us to gain insight and guidance regarding this strategy.
Timing is also critical. If refinancing before the exchange, do it at least half a year in advance to avoid IRS scrutiny. The same timeframe applies to those who intend to refinance after the exchange.
Finally, maintaining a clear investment intent is important. Ensure that the property continues to be used for investment or business purposes, as required under 1031 exchange rules.
Cash-out refinancing of a 1031 exchange property is a strategy that allows you to access equity. Given that you’re not allowed to have direct control of the funds during the exchange, you can only try for refinancing before or after the transaction. Even so, this practice can be risky and prone to IRS scrutiny. Working with tax experts, timing the refinancing correctly, and showcasing investment intent are some practices you can follow to potentially minimize IRS audits and increase the chances of maximum cashouts. Contact Realized 1031 today for more details.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.investopedia.com/terms/r/refinance.asp