1031 capital gains on investment property

[Spencer Howe]

We did a cash out on an investment property for 375k and now we are trying to sell but have just been informed we need to pay off the loan in order to do a 1031 and avoid capital gains. Is there any alternative to me loaning 375k for a day? House is making a profit on sale

Thanks!

[Dave Foster]

@Spencer Howe, reading your original post it seems the water is getting a little muddied over the issue of the refinance.  Take that out of the equation for a minute.  

Your requirements to defer all tax in a 1031 are to purchase at least as much as your net sale (contract price minus closing costs).  And you must use all of your net proceeds (the net sale minus mortgage payoff).  Any loan against the property is always paid off as part of the settlement.  It has to be in order to convey clear title to the buyer.

So right off the bat it's important to understand that you wont have to "loan" the $375k payoff.  It's just part of the regular transaction.  But it does leave you with less net cash to reach your reinvestment target.

Let's say your property is selling for $530K and there are $30K of closing costs.  That makes your net sale $500K.  The mortgage is paid off and that leaves you with $125K of cash that you need to use to purchase at least $500K of replacement property.  You can purchase less than you sell and you can take cash out.  But when you do the IRS interprets that as taking profit and you pay tax.  Since this is an investment property the two year residency for a primary exclusion does not apply.  

You can add money of your own to reach the reinvestment target.  Or you can take out new loans.   That doesn't matter as long as you purchase at least $500K and use all $175K to do that.

The $375K you accessed is yours to spend however you want.  It did not create a taxable event.  If you used it as part of your regular business operations then there would not be a question of it's validity.  Since you did it last tax year it is separated by two tax returns which also lends to it's transparency.  In the past the IRS has looked at cash out refis before a sale (same tax year or within a year) as potentially being a way of you accessing profit ahead of a 1031.  The easiest mitigator to this is to refi when you want but use the proceeds for reinvestment.