Cash out refinance: before or after 1031 exchange?

Question

I have a few rentals houses that have 200-250K in equity in each. I'm planning on selling ONE of them in the next year or so partly due to the HOA but also because of other reasons. Last time I did this I just took the equity in a house and 1031 exchanged it into TWO new properties. I never cash out refinanced.

Due to the market I don’t know if I want to buy TWO new houses with the equity from this one, since the market is at least slowing down and may go down in the coming years, the economic indicators are starting to show weakness in the economy. So I’m considering just buying one new house with part of the equity from the sale and cash out refinancing the remaining equity before or after the 1031 exchange.

I figure if I do a cash out refinance before a 1031 I can take the remaining equity in that house and use it as a down payment for another house, but this way I also have a down payment for another house when there are deals to be had again. If I wait until I buy another house with this equity and then try to cash out refinance, the market may already be correcting by then and it may be too late. Now, I do already have a lot of dry powder for another correction, but I’m trying to bolster my cash position as much as possible. As good real estate has been to me in the last 8 years, it would have been 10 times better had I had the capital to buy 10 houses in 2011. I bought one a year, but it took a year or so to save up a down payment each time. This time I will have tons of capital ready to deploy. So what to do, cash out refinance before or after a 1031 exchange? Or should I just do what I did last time and stick the money into two new houses instead of cash out refinancing?

Dave Foster · Answer

@Jack B. There's a time and place for leverage and a time and place to get conservative. All depends on the view from your seat or @Brian Garrett's.Fortunately for our clients we've introduced them to a hybrid approach that gives you a little something on each side. Go ahead and purchase two properties. But make one of them cash and one of them highly leveraged. You still have to dig in and find the right deals. But a cash play for cash flow is going to be your ace in the hole as a hedge against a downturn. It's also going to be and asset that is refi ready for when deals are to be had.Meanwhile the highly leveraged property boots your net roi as Brian would prefer. But risk is only to that property. You've separated a lot of your risk from your cash.

Jack B. · Answer

As I noted, buying two more properties in a slowing market is a risky proposition. Buying them while the market is still sky rocketing and that rocket is just getting started is great, but buying after a few years of unsustainable growth at what could end up becoming the beginning of the next decline, would tear into my net worth hard and fast. Buying one is basically just trading one for another.Also, I can buy a larger house that rents for more with the equity in this property. Right now the equity is getting me an even lower return than what you stated as I can't rent this house out for that kind of rent. It's dead equity...

Brian Garrett · Answer

Why would you want to put $250k down on a $500k house? Especially to only get $800-1,200 in cash flow?At $1k/month cash flow that's only a 4.8% return.That's lot of dead equity sitting there and for a very low ROI in my opinion.

Jack B. · Answer

Agreed, thanks. Now I wonder if I'm better off buying one replacement property with the money or two. I exchanged one for two a year or so ago.If the market keeps going up, buying two more would be best. If it goes down (it has corrected a little already, but it's not 100% clear if it's going to slow even further or if it's just a blip on the radar) then buying two will hurt net worth wise as I will be losing net worth even faster.A pro of buying only one more with the proceeds would be that it should cash flow really well. I estimate $800-$1,200 cash flow per month with a 250K down payment on a 500K house IF I buy the right deal. And that is factoring in vacancy, capex, etc.

Dave Foster · Answer

@Jack B. A cash out refi prior to a 1031 exchange looks to the IRS as exactly what you are attempting to do - access profit ahead of an exchange. So if examined there is a much higher rate of disallowance than if you cash out after the 1031 is complete when you are simply borrowing against the equity in your property.Unless handled correctly you'll not better yourself anyway. Remember you must purchase at least as much as you sell and use all of the proceeds in the purchase or purchases. So to avoid all tax you'll have to replace debt anyway. While sitting on the cash from the refinance you'll be paying interest on the new loan. I spose there's a case to be made for pre-empting a market correction where you can't refinance. But refi after the 1031 is the conventional method.

Jack B. · Answer

According to this it's best to wait until AFTER the 1031 exchange as the IRS frowns upon cash out refinances before a 1031 exchange, even 8-12 months before perhaps. https://www.accruit.com/blog/cash-out-refinance-or...