Avoiding Capital Gains through Cash Out Refi?

Question

🤔 I was wondering if an investor can minimize capital gains by doing a cash out refinance before selling the property.

Let’s say I have $100k equity in a rental. The property is worth $200k. I do a cash out refi and get $80k out of the property. Now my loan balance is $180k.

If I sell the property for $200k, am I now only paying capital gains on the $20k profit?

(Note: The scenario was made to be simple just to get an answer.)

Dave Foster · Answer

@Ryan Copeland, I'm with @Jaron Walling, I love the thought but your equity has nothing to do with tax.  A cash out refi is not a taxable event (which makes it an awesome tool to access equity).  But it doesn't reduce tax.

Your taxable gain is the difference between the net sales price (contract price minus commissions and closing costs but not mortgage) and your adjusted cost basis. Adjusted cost basis is your purchase price plus capitalized improvements minus depreciation.

That determines your gain.  So actually it is possible to walk away from a sale with a huge taxable gain and no cash from the sale to pay it.

the way to avoid tax and access your equity is to sell and do a 1031 exchange so the tax is indefinitely deferred while you add properties to your portfolio.

Mark H. Porter · Answer

To echo some of this, the long-term strategy of deferred gains has been, put very simply, defer, defer, defer, die, inherit, stepped up basis, no taxes.

Of course, no one knows whether 1031’s or stepped up basis will survive this national debt crisis.

Dave Foster · Answer

@Ryan Copeland, A great question!!  And take my answer with a grain of salt because I am a QI for 1031s.  But I also have used them for myself for over 20 years.  Its a long steady game just like your 401K or retirement account.

1. It's a compound interest effect - every day you keep the tax dollars is money in your pocket from the deferred tax.  Defer $30K of taxes for one year and if you make 10% on your investments then you put $6Kish in your pocket instead of just paying the tax.  Defer that tax for 30 years and you directly benefited around $85K just from keeping $6K of taxes in your pocket.

2. As long as you own the new property (purchased in part with deferred tax dollars) you'll never pay the tax.

3. As long as any time you sell the property you do another 1031 you'll never pay the tax.

4. If you ever used the 1031 to get a nice vacation rental you could then use it yourself for some use.  All of the tax stays deferred.

5. If you ever decided to sell your primary residence then the profit from that could be tax free and you could put that money into your pocket and move into one of your former rentals - without triggering any tax.

6. You can 1031 from active to passive opportunities as you near retirement.  Still keeping the tax deferred and still getting depreciation benefits.

7. And when you die your heirs inherit your property at a step up in basis.  Which means that the tax goes away at that point.

The issue with simply doing cash outs is not that it is a bad plan.  But there are times to sell properties - with deferred cap ex, when the price is too good to pass up, when it's time to change locations or types of investment real estate, etc.  This is where the 1031 can help you keep the tax deferred longer than just a refi will.

They're both great tools.

Ryan Copeland · Answer

Hey Mark, I thought your name looked familiar.  I am on your email list for Homeshire.  I'd love to have a one-on-one conversation with you.

Thanks for the response.  Your response as well as others have helped to provide more clarity on 1031 exchanges.  I can do a 1031 exchange into other properties and do a cash out refi if/when I need the cash.  Yet continue to do the 1031 exchange to defer the taxes.

Let's say at age 70 I "retire" from REI.  On my future RE portfolio, I do a cash out refi and pull all of the money out of the properties.  I now have X amount of dollars to do with as I please and I didn't pay taxes.  I will my portfolio to my children and when they go to sell the portfolio the taxes are basically starting over for them.  Good strategy!

Chris Mills · Answer

That's correct @Ryan Copeland. Your heirs get a step up in basis, meaning their tax basis becomes whatever the property is worth when you pass (under current tax laws). They're essentially starting with a clean slate. Until then, you can "swap till you drop."

Mark H. Porter · Answer

@Ryan Copeland partially.  Any gain between when you pass and they sell would still be a capital gain.

Alexander Szikla · Answer

No, you would be paying capital gains on the cost basis minus depreciation.

Ryan Copeland · Answer

@Dave Foster thank you for the clarity.  In some instances I will keep properties and just keep doing cash-out refinances if I'm having good tenants and good systems in place.  Otherwise I guess I'll have to do a 1031 Exchange.

I do have a question about 1031 Exchanges though.  What's the benefit of deferring taxes if you're eventually going to have to pay them anyway?  Is it that you just keep doing the 1031 Exchange and never pay taxes, do cash out refis & HELOCs and then pass the properties to your heirs and I assume they won't have to pay taxes?

Jaron Walling · Answer

That's a genius idea but not sure if it's feasible. Hopefully other experienced investors can chime in.

@Dave Foster Do you have a answer for this? It feels like a 1031 exchange but it's clearly not.

Avoiding Capital Gains through Cash Out Refi?

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