It can be difficult to refinance a multifamily property that will be used in a 1031 exchange when the refinance includes a cash-out. There is potential for challenges from the IRS and logistical complexity that can make the process arduous. Every situation is unique, however, and, as is often the case with 1031 exchanges, having a well-motivated and properly designed and implemented transaction when refinancing with a cash-out can contribute to a successful result.
Why It’s Harder to Refinance a Property Used in a 1031 Exchange
Cash borrowed against an investor’s equity in a property is not subject to taxation, as it is not a capital gain—it is simply a loan. But in a 1031 exchange, funds from the sale of a relinquished property that are not used for the acquisition of a replacement property, referred to as boot, are subject to capital gains tax. Therefore, funds that are taken out of a refinance close to the time of an exchange can look a lot like tax evasion to the IRS.
Refinancing a property to be relinquished before a 1031 exchange and refinancing the replacement property afterward are generally seen as different situations. Refinancing of the relinquished property is less acceptable in the eyes of the IRS, although it may be most advantageous to the investor. For example, if the investor has a large amount of equity and low debt on that property, a cash-out can serve as a source of personal financing, providing the investor with cash on credit, and then go on to be used in a 1031 exchange for the same value as before the cash was taken out. This is exactly what the IRS objects to.
On the other hand, refinancing the replacement property immediately after the exchange can be burdensome for several reasons. The conditions of the existing loan may not allow immediate refinancing, or the conditions of the second loan may be significantly less favorable. In addition, the maneuver would require the payment of two sets of fees.
Having a properly motivated refinance ahead of a 1031 exchange may be considered acceptable to the IRS, including an investor who may want or need to make improvements to the property in preparation for the exchange, or there may be an unrelated investment opportunity that will only be possible by refinancing the property in question. Refinancing to optimize the property’s debt-equity ratio or to buy a sports car, for example, may elicit quite another reaction. The IRS can see refinancing for reasons such as those in the latter case as a step transaction—a series of transactions, each individually permissible, but when taken as a whole violate the regulations of a 1031 exchange. In that case, the subsequent 1031 exchange could be invalidated in its entirety.
Finding the Best Way to Refinance
As we see, many times the best way to refinance an exchange property is to complete the transaction well in advance of the 1031 exchange, so that it is unambiguously separate from the exchange. Alternatively, if refinancing is possible after an exchange, it is less likely to be seen as a step transaction—the replacement property simply becomes an asset, undistinguished from assets acquired in any other manner. Real-world circumstances can make implementation of those strategies complex, however.
Finding the acceptable balance between meeting an investor’s goals and IRS rules can be a delicate operation in a 1031 exchange. Legal and accounting advice is often needed and an experienced and knowledgeable qualified intermediary is essential.
At CWS Capital Partners, we have the knowledge and necessary relationships to assist and complete these complex transactions. CWS is a fully-integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country, and we employ a team of experts who can help you hone your investment strategy.
For more articles like this one, check out our 1031 Exchange blog posts.
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