If you’re like most real estate investors, chances are that you’re constantly evaluating your real estate portfolio to determine if your equity is being put into good use. And that means taking advantage of all the available real estate options to see if you could pull out your equity and reinvest it in a more profitable investment vehicle
There are really two ways that you can realize this equity in any of your investments: either you sell the property or you perform a cash out refinance. But which is better for you: selling your property and performing a 1031 exchange or refinancing the project and pulling your cash out?
First, what is a 1031 Exchange?
A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.
Take a deeper dive into 1031 exchanges.
And What is a Cash Out Refinance?
A cash-out refinance is a handy way to convert your investment property’s equity into cash while refinancing your mortgage at the same time. Its no different than when a homeowner refinances their home and takes additional cash out of the transaction, except you do it for your investment property. In addition to lowering your interest rate, a cash-out refi can help you fund personal projects or consolidate debt. This means refinancing to a higher amount than your existing loan, allowing you to use the cash difference on whatever you need to.
There are no restrictions on how you use the proceeds from a cash-out refinance – you can use it for any purpose you like (though there may be tax consequences). Some of the more common ones for home owners are home improvements or repairs, paying off other debts, education costs, starting a business or medical expense. In the case of real estate investors, the cash out refinance is typically used to acquire more property.
Which is Better: 1031 Exchange or Cash Out Refinance?
Well, just like every financial investment, there is no absolute certainty in their outcome. Before you can really determine which path is best for you, you should find out about their advantages and disadvantages.
What Are the Pros and Cons of Each Option?
One of the major pros with doing a 1031 exchange is that once the property is sold, you will receive a large chunk of money to reinvest in a larger real estate portfolio. However, with a 1031 exchange you lose control or ownership of the relinquished property. In addition, with several rules and tight exchange timeline, you may end up paying capital gains tax if you fail to meet each of the deadlines or requirements.
Cash out refinance on the other hand allows you to draw capital tax free since it is regarded as a mortgage loan. However, doing a cash out refinance will almost always increase your monthly debt service expense while reducing your potential cash flow which is a huge disadvantage.
Another pro of the 1031 exchange is that it allows you to achieve your goals with ease. If your goal is to look for the next big investment opportunity with decent cashflow, then the 1031 exchange is your best option.
However, if the property is already situated in a great location and you want to hold onto it for a longer period, you can simply cash refinance the property so that you can continue to receive cash flow while holding onto it.
Refinancing a 1031 Exchange Property: Before and After
The mechanics of refinance in 1031 transactions, prior to an exchange, are straightforward. The taxpayer pulls cash out of the relinquished property from a lender. This lender uses the equity in the property as collateral. Then, the taxpayer sells the property, pays off the loan, and then reacquires the debt on the purchase side of the exchange.
It is important that the debt is reacquired, otherwise the taxpayer will pay tax on the debt cancellation. If this happens without any issue, we can see how it can be financially advantageous. The taxpayer has pulled cash from the equity without triggering a tax consequence. This may be even more beneficial if the new debt on the purchase side has a lower interest rate than the refinance loan.
In addition, some tax advisors believe that it is better to refinance the replacement property after an exchange rather than refinancing the relinquished property before an exchange. In any event, it is important to consider the risks and discuss your plans with your tax advisor.