One of the potential benefits of direct real estate ownership is the ability to “borrow” against it. This is known as a “cash-out refinance,” and it involves applying for a new loan to pay off the property’s current loan, while obtaining extra cash based on that property’s equity.
Borrowing against property that’s owned is one thing. But can you borrow against a 1031 exchange property? Can you obtain a cash-out refinance on your replacement property?
The answer to this question is a little more complex. You technically can borrow against your exchange property. You could also be on the hook for capital gains taxes from a cash-out refinance.
One main in-stone requirement of a 1031 exchange is that the property you exchange into (the replacement property) must be of equal or greater value than the property you sell (the relinquished property). But there could be “boot” involved – in other words, any cash profits or non-like-kind property.
Cash boot occurs when you don’t use all the proceeds from the sale of your relinquished property to invest in your replacement property. And those proceeds will be taxed at the capital gains tax rate.
How does a cash-back finance operate under a 1031 exchange situation? This depends.
Pulling equity out of a relinquished or replacement property just prior to or just after completing a like-kind exchange might signal to the IRS that you’re trying to get away with tax-free cash. This is especially the case if there isn’t a specific or independent business purpose for a refinance. One example of a “specific independent business purpose” could involve the renovation of an exchange property.
But pulling money out of a relinquished or replacement property before or after a 1031 exchange could lead the IRS to call that gain “boot.” This, in turn, could trigger a taxable gain – something you’re attempting to avoid through a like-kind exchange.
This is not to suggest that it’s impossible to borrow against a 1031 exchange property. But consider the following if you need to take this action:
Separate the transactions. Be sure that any refinance transaction on which you embark is separate from the exchange sale/transaction. You want to let the IRS know that the two actions are not connected.
Extend the hold. If you want to borrow against the replacement property, hold it before commencing. A one-to-two-year hold could be enough to minimize IRS scrutiny on the property.
Focus on the replacement property. In many cases, it’s considered not as risky to refinance the replacement property (versus the relinquished property). Again, this should be accomplished post-closing and in a separate transaction.
Demonstrate a specific purpose. If you must borrow against your relinquished or replacement properties, define a specific need for the cash. Taking cash out to buy another property isn’t a specific need – the IRS would look on that as getting tax-free money.
The overall purpose of a like-kind exchange is to help defer capital gains taxes from the sale of real estate. Because of this, borrowing against a relinquished or replacement property without considering how this might be viewed by the IRS could cost you.
As such, when it comes to anything concerning the 1031 exchange (including borrowing against the property), be sure to check with a qualified tax advisor.