cash out refi tax implications after sale of investment property?

[Roxanne Rose]

Hi- here's my scenario and I need answers/suggestions around any loopholes or tax implications I should be aware of. This is all new to me but I think I have a plan. I want to do a $150,000 cash out refi on my investment property (already spoke to two brokers about this) and use that money as a down payment for my own home. All the numbers add up, so it's possible. Then I'm thinking about selling my investment property at the start of 2022 (when my tenants' leases are up so the units are empty) and rolling that over to a 1031 Exchange to buy a larger multiunit building and avoid the capital gains taxes. However, will I have to pay taxes at some point on the $150,000 cash that I pulled before the sale? Will I have to pay anything on the $150,000 after the sale of the house? My plan is to use that for a down payment on an owner occupied home. Thank you!

[Sean Ross]

@Roxanne Rose in normal circumstances a cash-out refinance should not trigger a tax event because loan proceeds are not income, and therefore they don't carry the normal consequences that receipt of income can carry. 

However, refinancing to pull out equity prior to a 1031 exchange can, but won't necessarily result in taxes owed.  This is due to what lawyers in this space call the "Step Transaction Doctrine."  (In short, this doctrine means that you can't do something across multiple steps that would normally be disallowed under a single step)

Imagine that you want to do a 1031 exchange but keep $150K of your equity after sale.  This creates taxable "boot" and you won't get full value from your exchange. 

Then imagine that you try to game the system by refinancing quickly before you sell, pull out the $150K, then do a 1031 exchange.  Clever, but here's where you run into problems with Step Transaction Doctrine. In this case the IRS could argue that your refinance loan proceeds actually constitute "boot" in the 1031. 

Here are some very short guidelines

• refinancing after you buy and complete the exchange is less tax-risky than refinancing right before you sell
• If you do refinance before you sell in a 1031, then your refinance should take place as early as possible and the primary purpose should not be for tax avoidance. 
• The refinance should, if possible, be documented as separate from the exchange sale so as not to look connected. 
• You should be able to show an independent reason for the refinance (the literature calls this independent "economic substance") so that it looks like you would have pursued the refinance whether or not you sold the property or did an exchange. 

Work with a tax advisor and QI on this. Some of this is subjective; some is not.  You want to make sure you're following valid established precedent to the maximum extent possible.