Refinancing an investment property is the process of paying off an existing loan and replacing it with a new one that has different terms. Investors may seek to refinance a loan’s terms for one or more of several reasons:
- To improve the terms such as interest rate or payment
- To increase or decrease the length of the loan
- To change from a fixed rate to an adjustable or from adjustable to fixed
- To “cash-out” by taking equity from the property
Depending on the overall market conditions, the property value, and the investor’s current credit situation, it may or may not be feasible to achieve those goals. Investors must also consider the upfront costs of refinancing when calculating the benefits.
For an investor considering or having completed a 1031 Exchange, the question of whether and when to refinance the property carries additional nuance. Because executing a 1031 exchange facilitates the deferral of capital gains taxes on profits earned on investment property, refinancing too close to the exchange could raise suspicion at the IRS and even result in the deal being ineligible.
Timing and Purpose Are Crucial
While a refinance that is completed too soon before or after the transaction of a 1031 exchange could cause the IRS to suspect that the investor is attempting to avoid taxes by obscuring profits, having a clear business purpose for the refinancing may help. If the investor clearly seeks a new loan for valid business reasons, it is less likely to raise the alarm at the IRS. For example, suppose the investor's records demonstrate that they will use the money to fund repairs to the property, pay for marketing expenses, or alleviate a financial shortfall. Those are legitimate reasons for seeking access to additional cash flow through refinancing.
While no clearly defined schedule exists for guidance, a good buffer zone between refinancing and initiating an exchange is a minimum of six months. However, it is probably better to refinance the replacement property than the asset designated to be relinquished. The intent of a 1031 exchange presumes that equity built up in the original property should be used to obtain the replacement property, not cashed out. If refinancing the first property is necessary for some business purpose, these actions may help the transaction pass through IRS scrutiny:
- Keep meticulous records of the need for the refinance and the use of the funds accessed, if any.
- Wait as long as feasible between the refinance and the exchange initiation. In no case should the refinance and the exchange sale closing be simultaneous.
If the IRS decides that the refinance is, in reality, a step-transaction designed to avoid paying taxes, the cash the investor receives during the refinance could be treated as a taxable boot. Worse, if the IRS determined that the transaction was deliberate, the exchange itself could be voided, and the entire sale would then be subject to capital gains taxes. Thus, it's wise to discuss a potential transaction like this with your tax advisor, and likely safer to defer the refinance until the exchange is finished.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.