Cash refinance and than 1031 how it works ?

[Ran Fridman]

Hello guys, we plan to take cash out refinance from one of our houses that are paid off ( no mortgage) and then 1031 exchange sale.  

Appraisal for our house value $ 200,000

Step # 1 - Cash out refinance $ 140,000

Step # 2 - 1031 sale of the house for $ 200,00, so we pay back $ 140,000 to pay off loan for Cash refinance.

What happens with $ 60,000 left do put in escrow or third party and now we need to buy new property for $ 200,000 or higher to avoid capital gains tax?

Thank you in advance for response.

Ran

[Henry Clark]

You can never touch the money as part of the sale.  

Sit down with a 1031 Intermediary and have them explain process and timelines.  

Don't understand why the loan.  When you sale the property the loan has to be paid off.  You might only have the loan for 1 day or 180 days.  Talk with the intermediary or your loan officer.  

[David M.]

@Ran Fridman

Consult with a qualified QI, e.g. @Dave Foster

the QI holds the funds, you or your attorney never get the funds.  If you sell for $200k, then you need to buy as much as $200k and at least as much cash you get from the deal (I think i got the latter half right).  

Just be sure you understand how to calc profit.  You need to know your cost basis.  It has nothing to do with your financing situation.  For example, if you buy a widget for $10 and sell it for $12, then your profit is $2.  It doesn't matter if you borrowed the $10 or used $10 from your pocket.  Consult a qualified professional.

Good luck.

[Ran Fridman]

Thank you my friend 

[Conner Jackson]

@Ran Fridman it's highly likely if you talk to a tax professional that they will advise against a cash-out refinance before you sell your property for an exchange. Unless it's done well in advance of a sale, the IRS views the refinanced loan proceeds as taxable boot since it is equity that won't be reinvested as part of the exchange. If you want to do a refi, wait until you complete your exchange and do a refinance on your replacement property. Some call it the nanosecond rule because you only have to wait a nanosecond to cash-out refi on the replacement property after closing on it. 

You will need to work with a QI for your 1031. They will receive and hold the cash proceeds from the sale and you will need to reinvest that into one or more replacement properties. Your reinvestment goal for a complete tax deferral will be your net sale price (sale price less allowable closing costs).

[Dave Foster]

@David M., thanks for that kind shout out!  @Ran Fridman, What you're trying to do is pull out money ahead of your 1031 so you can get cash in your hands tax free.  Totally legitimate desire.  But the IRS has read this playbook before many times.  And while there is no statutory prohibition - the IRS has tended to look at refinances right before a sale and 1031 as a way of pulling profit out.  and in many cases have disallowed these exchanges.  

They are willing to leave their tax in the game.  If you're willing to leave your profit in the game.  And when you do a cash out refinance right before a sale (conventional wisdom says within 12 months or so) you are taking part of the profit out.

The answer is to adjust your model just a little bit.  In order do defer all tax you must purchase at least as much as your net sale.  and you must use all of the proceeds from the sale in your purchase.  In your case this means you must purchase $200K of real estate using the proceeds of $200K.  Here's how you can make your plan work.

1. Sell the property and start a 1031 exchange.

2. Buy a new property for at least $200K using all of the proceeds (which must sit with your 1031 qualified intermediary between sale and purchase).

3.  Immediately after completing your purchase you then do a cash out refinance and take the $140K out.  When you do a cash out after a 1031 is complete the IRS no longer says you are inappropriately taking profit out.  Instead you are borrowing the bank's money secured by the profit that is in the form of equity in your property.  

This will have the same exact effect as your first plan.  But the IRS will not question the cash0out refinance.  And you don't have to have the loan out there costing interest until you're really ready to use the money.  You can simply let your new property sit and make money debt free until you have the need for the cash.  And it doesn't slow you down at all.

[Ran Fridman]

Thank you so much for your response and trying to help. 

Ran

[Christie Gahan]

You could just pay the tax.  Long term capital gains is 15% on the first aprox $500k and then goes to $20%.  This is a much better deal then on income, especially if you area self employed.  The advantage is , Duh, you don't have to put the money in real estate.  It can be really smart to get a good accountant that likes tax strategy and look at all investments in your life.  Sometimes, it is better to pay the tax and put the money in something besides real estate if that gives you a balanced portfolio.  I have known people who 1031 for 30 years and then get jammed up because they have created a tax burden.  If they sell, they have a huge tax bill due.  It is okay to take a profit and pay the tax.  Invest in stocks or bonds, pay off other debt or , heck, enjoy spending some of your money.  

[Sean Ross]

Just a quick follow up to @Christie Gahan's comment:

** Yes, Long term capital gains are taxed at lower rates, but it isn't as simple as the first $500K of gains are taxed at 15% -- rather, the 15% bracket will account for your total income from all sources.  If you have $250K of W-2 or 1099 income, for example, then only the first $250K of your LTCG will get the 15% rate.  Once your total income (including LTGC) crosses the $500K threshold (which is really about $519K in 2024), then it flips to 20%. 

  ** Remember @Ran Fridman that you are also likely facing recaptured depreciation taxes (25%) and possibly NIIT taxes (+3.8%) on sale, plus state taxes on income (+4.95% for IL).  Your total tax % on long term capital gain income is very unlikely to be as low as 15% -- but it's still almost certainly lower than ordinary income. 

  ** Christie makes a good and important point that just paying the tax up front will give you greater flexibility in terms of reinvestment options.  You just lose out on the efficiency created by the 1031 structure. 
  

[David M.]

just to add to that.. take a look at your tax return and see how much PAL (Passive Activity/Allowed Losses) you have built up.  They will help offset your tax liability.  For whatever reason, its not talked about enough.

Also, checkout my post here of an actual example of where its cheaper to sell, then try to cash out refi:  https://www.biggerpockets.com/forums/48/topics/1169308-equity-rich-need-advice?highlight_post=6659747&page=1#p6659747

As @Christie Gahan said, paying tax isn't bad.  Being spiteful about paying taxes can be very bad.  For the tax you pay, you just need to be doing it efficiently.

Good luck.