Broker Check

Understanding the Impact of Cash-Out Refinancing

March 12, 2024

1031 exchanges offer investors a powerful strategy to defer capital gains taxes and depreciation recapture when transitioning from one investment property to another. However, the intricacies of IRS guidelines can present challenges, particularly when it comes to cash-out refinancing. In this article, we delve into the potential pitfalls and considerations surrounding cash-out refinancing in the context of a 1031 exchange.


The Potential Problem with Cash-Out Refinancing:

While engaging in a 1031 exchange, an investor is allowed to defer taxes by reinvesting proceeds from the sale of a relinquished property into a replacement property of equal or greater value, cash-out refinancing poses a risk to this tax deferral strategy. IRS rules dictate that investors must not have any "net debt relief" and must match or exceed the debt on the replacement property compared to the relinquished property.


Refinancing a Relinquished Property Prior to Closing:

Refinancing a relinquished property before closing can allow investors to extract cash by paying off existing mortgages and replacing them with larger loans. While this may appear advantageous, the IRS views such actions unfavorably, considering them a prohibited step transaction. However, if the refinance is not undertaken in anticipation of a 1031 exchange and has independent business reasons, such as property repairs or cash flow issues, investors may still qualify for a full exchange.


Refinancing a Replacement Property After Closing:

On the other hand, post-exchange cash-out refinancing on a replacement property typically does not impact tax deferral. As long as investors adhere to the exchange rules and demonstrate an obligation to repay the debt, the IRS generally permits such refinancing without jeopardizing the exchange. However, it's prudent to avoid concurrent refinancing with the replacement property purchase and if needed wait until the exchange is completed before arranging refinancing to mitigate IRS scrutiny.


Navigating cash-out refinancing in the context of a 1031 exchange requires careful consideration and consultation with tax, financial, and legal advisors. While refinancing can offer financial flexibility, it's essential to understand the potential tax implications and ensure compliance with IRS regulations.


Scott Offerman helps investors navigate obstacles and fix problems which commonly occur during a Real Estate Investment Sale utilizing a 1031 Exchange.


Scott Offerman

Founder

1031 Financial

scott@1031financial.com

Cell: 917-887-0166

www.1031financial.com

By Appointment Only

321 West 44th Street, Suite 200

New York, NY 10036