After posting my recent blog entitled “Can I Refinance My 1031 Property” I received the following question:
“Paul, can I obtain tax-free cash from a rental property by refinancing it?”
The answer is YES - provided several important steps are followed which we will review in this blog.
Many investors who have realized appreciation in their properties fail to consider that the
equity in their properties can be converted to cash that can be spent for whatever they desire such as taking a vacation, buying a new car, or paying for the education of their children. When you obtain funds by taking out a loan, the funds are generally available to you tax-free. Of course, the loan would need to paid back at some time and along the way you would need to make loan payments. Also, if debt remained on the property at time of sale, you would need to replace the amount of debt with new debt on your future replacement property or with cash from outside the exchange. However, the benefits of what you potentially do with the funds might outweigh the costs of the loan.
Tax authorities frown on taxpayers who borrow money immediately before or after an
exchange to simply avoid paying taxes and there have been cases of audits triggered by timing concerns*. While there are no specific sections of tax code that details the length of time required to avoid possible tax consequences, tax advisors in our network generally recommend that any refinancing should not occur within a short amount of time just before or after an exchange. As a further step, any refinancing should not be referenced in sales or 1031 exchange documents as a condition of the sale or exchange. The financing should be completed outside of the time period during which the exchange occurs – and more time before or after is better.
It is important to document the purpose of the funds that are obtained via a loan to avoid
accusations that the loan was done solely to avoid paying taxes – especially if the loan was
completed relatively close to the 1031 exchange. Valid reasons for seeking a loan could include improving or repairing the property, paying for healthcare or other critical services, paying bills, or investing in other opportunities e.g., other properties, stocks, bonds, etc.
If the loan is completed near the time of the 1031 exchange, it is especially important for you to receive support of a qualified tax advisor who will sign your tax returns for at least the year in which exchange will be reported. Any steps that you take to obtain tax free funds and your intent to use the funds should be well documented to reflect that your objectives were other than tax avoidance.
Through refinancing a rental property, an investor can potentially obtain tax free funds that
may be better utilized than remaining as unrealized trapped equity in the property. While each refinance in your rental property requires a unique analysis keep in mind that time and specific business purpose are a couple of most significant factors staying in good graces with the tax authorities.
Please note that we are not allowed to provide individual tax advice and you should seek the assistance of a qualified tax professional before acting on the information provided in the blog.
Finally, please consider that refinancing of a property can raise the risk of foreclosure in the
event that the debt payments cannot be sustained due to loss of tenants or an economic
downturn.
If you wish to contact a qualified tax advisor for more information about tax free refinancing options – or have other tax deferral or investment questions, please contact us at 408-392-8822 or via email at info@FGG1031.com.
*Fred L. Fredericks v. Commissioner, TC Memo 1994-27, 67 TCM 2005 (1994)
*IRS Private Letter Ruling 8434015