Cash out Refi of 1031 exchange

[David D'Ambrosio]

Lets say you use 100K of capital gain to buy a 100K rental property using a 1031 exchange.  Can you shortly thereafter do a  cash out refi, take that 80K in cash without owing tax on it?  I may be in a situation soon where I will have a capital gain of 100 or more.  My original strategy was to use that money as a down payment of 4-5 properties, but wanted to know if I could instead buy fewer properties and do cash our refis to access the cash without incurring the capital gains.  

[J Scott Hamilton]

If you try to take cash out of a property around the time that it is being traded in a 1031 (Like Kind) exchange, the IRS will try to apply the “step transaction doctrine” to characterize the cash taken out as 'boot'. Boot is normally cash or non-like kind property that is taken as part of the exchange, and there is usually a taxable amount of the exchange equal to the value of the boot. So for these exchanges the rule of thumb is to trade up in value, not down, to avoid getting taxed on boot.

Now having said that, the IRS has lost some court cases where a refinance was unrelated to the exchange itself. You might find some people have used creative ways to leverage these court rulings, but they likely add additional expense and complexity to the transaction. Even plain 1031 exchanges have enough rules to follow that circumstances of the exchange, such as not closing on the new property fast enough, can cause you to lose the tax benefit.

If your big picture is to sell one property and buy multiple, or even to sell an SFR and buy a multi-unit, that can already be done under 1031 if you identify replacement properties equal or greater to the value of the property being sold. The IRS does not use a narrow definition of "like kind" when it comes to passive income properties. But if you are just trying to cash out and still roll forward the gains, you're going to be fighting the spirit of the 1031 exchange.