One tried and true commercial real estate investment strategy is to buy a property at a good price, finance it with a short term loan, complete renovations or improvements, lease it up at higher rental rates and then perform a cash out refinance to take a dividend from the property. While this strategy can work in many instances, there may be some added complexity when the transaction includes a 1031 Exchange.
In this article, we are going to discuss Cash Out Refinances After a 1031 Exchange. We will describe what this is, how it works, and when it is allowable. By the end, real estate investors considering a 1031 Exchange will have the information needed to determine if a refinance is a good fit for their needs.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. During the normal course of our business, we often assist individuals with the placement of their 1031 Exchange funds. If you are an Accredited Investor looking to complete a 1031 Exchange and would like to learn more about our current investment opportunities, click here.
What is a 1031 Exchange?
Before discussing how a refinance factors into a 1031 Exchange, it is first helpful to orient ourselves by clarifying what a 1031 Exchange is.
A 1031 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sale proceeds into another commercial rental property that is “like kind” to the one that was sold. In 1031 Exchange parlance, the sold property is known as the “Relinquished Property” and the newly purchased property is known as the “Replacement Property.”
To receive full tax deferral, the IRS defines a number of rules that real estate investors must abide by in the completion of the exchange transaction. Among the most important:
- Both properties must be held for “productive use in a trade or for business or investment.”
- The Replacement Property must be identified, in writing, within 45 days of the sale of the Relinquished Property and investors must complete the purchase within 180 days.
- The debt and equity received from the sale must be the same or greater than the debt equity used in the purchase of the Replacement Property.
- The Replacement Property cannot be immediately flipped purchase.
- The exchanger/taxpayer cannot receive any “taxable boot” from the transaction – if they do, taxes may be imposed on it.
To help comply with all of the rules, it is a best practice to use a “Qualified Intermediary” which is a firm or individual who helps to facilitate the exchange transaction. If any of the rules are violated, some or all of the transaction could become taxable.
Now, in most cases, the rules are very clear and prescriptive. But, in other cases, there may be some gray area where there may be some room for interpretation. One of those areas pertains to the financing and refinancing of the property involved in the deal.
What is a Refinance?
A “refinance” transaction is one where a borrower/investor obtains a new loan, often at a lower interest rate, and the proceeds are used to pay off an existing loan. If there is a difference between these two amounts, it is cash that is kept by the exchangor/taxpayer. This is why it is called a “cash out refinance.”
Refinancing The Relinquished Property
Remember that the Relinquished Property is the one that is going to be sold. Also remember that one of the 1031 Like Kind Exchange rules is that the taxpayer/investor must reinvest all of their equity into the new property.
With this in mind, it is possible that the IRS may not look favorably upon completing a cash out refinance on the to be Relinquished Property immediately before it is sold because they could view it as taking equity out of the property, which should be reinvested into the new property. The idea behind this is known as the “step transaction” doctrine which allows the IRS to treat seemingly disparate transactions as the same. In this case the refinance and then the sale/1031 Exchange would seem to be unrelated, but the IRS could put them together and look at them as two parts of the same transaction in which the refinance net proceeds are treated as “boot” – which is taxable.
When attempting a refi of a soon to be sold property, the key to determining the proper tax treatment is that the IRS is going to look to see if the refinance transaction has an “independent purpose” that is separate and distinct from the 1031 Exchange. If it does, the loan proceeds received may not be treated as boot. If it doesn’t, the IRS may determine that the proceeds are boot and assess some amount of tax on the transaction.
Refinancing the Replacement Property
In this scenario, an investor would sell the Relinquished Property and then use the proceeds to purchase the Replacement Property. Then, shortly after the purchase of the Replacement Property is complete, they complete a cash out refinance.
In a post-exchange refinancing, the same principle applies. The IRS would look to see if the refinance transaction has an “independent purpose” that would justify it so close to the completion of an exchange. If it has one, the transaction may stand. If it doesn’t, the IRS could determine that the proceeds are boot and tax them.
So, given the view on a refinance that is completed in close proximity to either side of a 1031 Exchange, it is a very valid question to ask, “what is an appropriate amount of time to pass before a refinance can be completed?”
When Can an Investor Refinance After a 1031 Exchange?
Every transaction is unique so it can be difficult to make a blanket statement about how long to wait before completing a cash out refinance, while still achieving the tax deferral goals of a 1031 Exchange. But, the general rule is that the longer after the exchange is completed, the better and real estate investors should wait at least 6-12 months before attempting a refinance transaction with the exchange property.
Steps That Can Be Taken To Ensure a Smooth Refinance
While there is no guarantee that the IRS will not scrutinize a refinance after the completion of a 1031 Exchange, there are a number of steps that investors can take to minimize the chance of this happening. They include:
- Clear Purpose: Investors should easily be able to demonstrate a clear business purpose for the refinance transaction by keeping detailed records of the refinance and the reason for it. They could come in handy in the future should the IRS ever request any information about it.
- Independence: The refinance transaction should be completely independent from the 1031 Exchange. For example, the transactions should have separate closings and the funds for each should also be kept separate.
- Time: Again, the further apart these transactions are completed, the better. At a minimum investors should wait 6-12 months.
- Expertise: Finally, these transactions are complicated. As such, it is a general best practice to seek the help of experts such as a dedicated tax advisor, real estate attorney, and/or CPA before initiating an exchange/refinance for a like kind property. They may cost some money up front, but this cost can potentially result in significant savings down the line.
Again, taking these steps is no guarantee that the transaction will not receive any scrutiny from the IRS. But, they will likely minimize the chances that this happens.
Cash Out Refinance in a 1031 Exchange & Private Equity Real Estate
Both a 1031 Exchange and a Cash Out Refinance are time consuming, complicated transactions. And, the more dollars involved, the more complex and time consuming they can become. For this reason, many individual investors avoid them or, at the very least, aren’t aware of all of the requirements that go into completing them. For this reason, investing in a syndicated deal offers a compelling alternative to the go it alone approach.
In a syndication, individual investors are provided with the opportunity to purchase a fractional share of an institutional quality asset, as opposed to managing the whole property/transaction themselves. There are a number of benefits to this approach including passive income, expertise, and hands on management meant to maximize property cash flow.
With regard to a 1031 Exchange, syndications can be used as a Replacement Property, which can eliminate the time crunch for many investors. In addition, it allows the syndication firm to make all of the important operational decisions around things like when to complete a cash out refinance of the property.
Summary of Cash Out Refinance After 1031 Exchanges
A 1031 Exchange is a tax avoidance strategy that allows individual investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into another, like kind property of equal or greater value.
A cash out refinance is a financial transaction where an investor gets a loan, usually at a lower interest rate, and uses the proceeds to pay off the balance of an old loan.
In order to keep the tax deferral benefits of a 1031 Exchange intact, there are a number of rules that investors must abide by and one of the important has to do with when an investor can perform a cash out refinance in close proximity to the exchange.
As a general rule, the IRS may view a cash out refinance completed right before or right after the completion of a 1031 Exchange as an attempt to take equity out of the exchanged property.
Investors should wait at least 6-12 months between the exchange and the refinance to minimize the chance of additional IRS scrutiny.
Given the complexity of these transactions, it is a best practice for investors to work with CPAs and tax advisors to make sure all of the rules are followed and to minimize the potential tax bill.
Interested In Learning More?
First National Realty Partners is one of the leading private equity commercial real estate investment firms in the United States. We leverage decades of expertise to find world-class, multi-tenanted assets available below intrinsic value. We seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our investment opportunities, contact FNRP at (800) 605-4966 or firstname.lastname@example.org.