Refi + 1031 Exchange: How is it treated?

[Rich Jordan]

CPAs of BP,

If I cash-out refinance one of my apartment buildings in, say, year 2...

...does that change my basis if I attempt to 1031 Exchange down the road, say, in year 4?

If not, am I expected to come up with that equity that I had already pulled out and deployed into other projects?

I imagine this is a simple answer one way or the other. Trying to make sure my repositioning and exit strategies are actually viable. Thanks.

[Mark Creason]

@Rich Jordan

@Dave Foster

Rich,

If you take cash out of a refinance, 2 years before sale, you would not have to place that cash into a deal.  For instance, you buy for 100k cash, several years later you refinance for 150k, then 2 years later you sell for 200k paying off 150k, you would need to reinvest 50k cash into your 1031 but purchase at least 200k for your 1031.  You could fill that 150k either with cash or debt.  If you were to change your refinance to 2 months before selling, you might have issues with the IRS.  They frown on a refinance right before sale.  Strangely, they are less concerned with a refi after your 1031.  Thought it was worth bringing up the short term refi.

Mark

[Dave Foster]

@Rich Jordan, it doesn't change your basis at all.  Basis is what determines your profit and refinance does not impact profit at all.

But.. you do indeed have to make up that refi amount if you do a 1031 and don't want to pay any tax.  The requirements to fully defer tax in a 1031 are that you purchase at least as much as you sell and you use all of the net proceeds in the next purchase.  So there is an underlying relationship between your refi and the cash you'll have to reinvest to purchase at least as much as you sell.

When folks are using the Brrr approach they'll try to leave enough equity in the property to be used as a sufficient down payment on their next 1031 property.  While at the same time having already used the refi money for another property somewhere els.

You don't specifically have to take out the same amount of debt as you have in your old property.  You can bring in cash from any source.  Most folks don't have access to those kind of funds so they take out new debt in the replacement property.

[Rich Jordan]

@Dave Foster Thanks for your response. Want to make sure I'm interpreting this correctly...

Are you saying that if all proceeds from sale are invested in next property through 1031 and formerly refi'ed funds were invested in like-kind property, then it's all good?

Further laid out:

Equity from Sale - Refi Equity => Equity in next property

+

Refinance Proceeds => Equity in another like-kind property (previously)

=

Thumbs up from IRS?

[Dave Foster]

@Rich Jordan  Ummmm maybe.  I think that's what you're saying.  

Easiest way to understand it is that any refi has no bearing on 1031 or profit at all other than the pay off of the refi which adjusts your net proceeds..  

To complete a 1031 with no tax due you must purchase at least as much as your net sale and use all of your net proceeds in the replacement property.  If you sell for $200K and owe nothing then you must purchase at least $200K in real estate and use all $200K of net proceeds to do that.  If you sell for $200K and owe $150K then your net proceeds are $50K.  You would have to purchase at least $200K in real estate using the $50K proceeds in the purchases.

When you take a refi out it is for your use.  The use of it has no direct bearing on gain or 1031 or anything.  The only time you get into situation of use of your refi is if you're trying to deduct interest from it but using it for personal use.

Thumbs up from the IRS until they decide otherwise.  Which can be anytime they want of course :)

[Mark Creason]

@Rich Jordan

@Dave Foster

Rich,

If you take cash out of a refinance, 2 years before sale, you would not have to place that cash into a deal.  For instance, you buy for 100k cash, several years later you refinance for 150k, then 2 years later you sell for 200k paying off 150k, you would need to reinvest 50k cash into your 1031 but purchase at least 200k for your 1031.  You could fill that 150k either with cash or debt.  If you were to change your refinance to 2 months before selling, you might have issues with the IRS.  They frown on a refinance right before sale.  Strangely, they are less concerned with a refi after your 1031.  Thought it was worth bringing up the short term refi.

Mark

[Rich Jordan]

That's great info @Mark Creason! 

Thanks for clearing that up. So 1031s are more concerned with *value* of the new property being greater than or equal to the *value* of the sold property. I had always thought it was the relationship of the equities, not the values. Gamechanger for me. Thanks!