Clients often ask us if there are ways to convert a portion of the appreciated equity in their rental properties to cash without paying taxes. The answer is a qualified “yes” provided you follow the guidelines detailed in this blog post.
Cash received in the form of a loan on a property is generally not subject to federal or state taxes. For example, if you own a property with low or no debt on it, you may be able to either take out a new loan or refinance an existing loan and obtain tax-free cash that you can generally use as you wish.
Tax authorities however may deem that if a cash-out refinancing is completed immediately prior to or after completing a 1031 exchange, the investor will incur a tax liability for the transaction. Let’s consider the logic of this position.
You may recall that one of the requirements for completing a 100% tax deferral is that all the net proceeds from the relinquished or sold property must be reinvested in “like-kind” replacement properties. Tax authorities take the position that cash received immediately prior or after the exchange results in not reinvesting all of the net proceeds from the relinquished property. Therefore, the refinance loan proceeds would be characterized as mortgage boot and be taxable. For tax purposes, the IRS can reclassify seemingly independent transactions as a single transaction under what is referred as the "step transaction doctrine.”
If the IRS believes there was no independent commercial reason for the refinance, the consequence can be unfavorable for the investor. One of the keys to avoiding this undesirable outcome is to be prepared to demonstrate that the motive in completing the transaction was to achieve a business objective other than attempting to avoid paying taxes.
In a notable IRS precedent set in 1994, an investor who had refinanced a property less than a month prior to concluding a 1031 exchange was audited. The investor successfully challenged the audit by demonstrating that he had attempted to refinance the property for a business purpose during the past two years.
Investors who wish to explore cash-out refinancing should discuss their plans with a qualified real estate tax advisor and consider the following guidelines to help avoid potential tax consequences.
- Plan to complete a cash-out refinancing well before or after the 1031 exchange. Many tax advisors that we work with would advise to complete the transaction no less than a year from time that the exchange is completed.
- Be prepared to document reasons for the refinancing that are unrelated to saving taxes during the exchange. Reasons for obtaining funds might include investments, health issues, solving other financial problems, etc.
- Avoid documenting any linkage of refinancing actions with the sale or purchase of properties in your 1031 exchange. The sale and refinance transactions must not be viewed as dependent on each other.
Conclusion
Cash out refinancing can be utilized to convert appreciated equity in rental properties to tax-free cash. Added debt will of course need to be repaid at time sale – but the benefits of freeing up cash to achieve desirable outcomes may be preferable for some investors.
Our team at First Guardian Group is pleased to help you further evaluate cash-out refinancing and various investment options to find those that may be most suitable to meeting both short- and long-term objectives.
Contact us today to schedule a consultation with one of our advisors.
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