We all know that a tax-deferred exchange allows you to defer capital gain taxes but there is another strategy to help you get a great return on investment and tap into your equity. Today’s Thankful Thursday is about refinancing to pull equity out of your replacement property.
The most pressing question is when is it ok to refinance? The answer to this question varies but Exchangers who are planning to complete a 1031 exchange are typically cautioned against refinancing the relinquished property before selling. The IRS frowns upon this step-transaction: one step in many steps that may potentially result in the Exchanger not reinvesting all of the equity from the relinquished property. That said, you may be able to refinance if you can show an “independent economic substance” or a valid business reason to incur additional debt prior to selling. A few times we see Exchangers refinance the relinquished property before selling it include refinancing the same principal at a lower rate, borrowing to get funds for an earnest money deposit for an intended replacement property or making needed or required improvements before selling. Refinancing the replacement property, however, is a different scenario.
The only loophole associated with a 1031 exchange is the ability to refinance immediately after the replacement property is acquired. This allows you to reinvest the value and equity you had in your relinquished property while providing the opportunity to pull equity out of the property to make improvements, expand or do whatever you wish after the exchange is complete.
While some are concerned that refinancing the replacement property potentially carries the same risk as refinancing the relinquished property, many feel it is all about timing. If you refinance after the replacement property closes, the refinance is not shown on the replacement property closing statement and your exchange is complete. Some advisors think there is no reason to wait after acquiring the replacement property, regardless of the reason, and some recommend waiting a year or two until the exchange is considered “old and cold” unless there is independent economic substance to the refinance, such as using the funds to improve the replacement property. Some advisors will encourage their clients to consider refinancing the replacement property rather than exclude funds from a 1031 exchange and having to pay tax on the trade down. Of course, it is recommended that you consult your tax advisor to discuss your exchange and any desire to refinance. It could be the perfect way to have your cake and eat it, too.