I agree that this is tax planning that the IRS does not like. I stand by my assertions based upon the following citations given to me (I have not done nor verified this research, though I have confidence in its accuracy):
The Tax Court held that the assumption of a liability by a taxpayer in a like-kind exchange will be recognized even though the liability was placed on the property immediately before the exchange at the taxpayer’s prompting so as to avoid the recognition of gain under the mortgage netting rule (Garcia vs Comm., 80 TC 491 (1983)) and PLR 8248039). Refinancing after the exchange also should be permitted (Carlton v. U.S., 385 F2d 238 (5th Cir)(1967)).
Refinancing during the exchange, if the taxpayer is allowed to touch the cash, is a taxable event.
I have a tenant/buyer in my condo. The lease/purchase agreement expires the end of october at which time they will purchase the property. I want to avoid Capital Gains tax so I plan on doing a 1031 roll over into another investment property. To avoid having ALL the equity roll over, is there anything wrong with refinancing, pulling out as much tax free cash as possible then roll over the remainder to the next investment property?
If I’m following you right, I’ve done this before. It will work, except that you’ll have less money available for your exchange. And if you as you said, you want to “pull out as much tax free cash as possible” then you would have very little $ left for the exchange. Also remember your closing costs when you sell. They could be big, and that could eat into your available exchange money even further. That in turn could make it much harder for you to find a good buy during the time limits imposed on the exchange, (because you’ll have a much smaller down payment) which in turn could either push you into a bad deal, or screw the whole exchange and make you pay a lot of taxes anyway.
It wasn’t clear why you want the cash. If for example it’s to do repairs on a third property somewhere, go ahead as long as you realize you’re robbing Peter to pay Paul - e.g. you would have more $ for one property, but less $ to buy another. If you want just a little cash for spending, then an alternative idea is when you sell you can direct your 1031 Exchangor to give you a portion of the gain in cash, but of course it then becomes taxable income and isn’t available for the exchange.
If you just want a lot of tax free $, it would be best to do this on a property you don’t intend to exchange if you can.
Feel free to e-mail me if you have any more questions on this.
This may actually be good tax planning. In a tax-free 1031 exchange, you have to apply all the proceeds of the sale on your relinquished property to the purchase of a replacement property of equal or greater value.
Borrowed money is not taxable income, because it must eventually be repaid. Doing a cash-out refinance before the sale of the relinquished property lets you convert some of your equity to cash outside the exchange umbrella. If you wait until the exchange is underway, any cash you withdraw from the 1031 transaction is taxable.
As an alternative, you can complete the exchange, THEN do a cash-out refinance of your replacement property to convert your equity to cash.
since i have never done a 1031 exchange im not exactly sure of the nis and outs, but what you are suggestnig sounds to me like tax evasion of some kind. maybe not, but it seems too simple to be that easy. my guess is that you will be facnig some sort of loan fraud (if you state that the refied equity will be used for home improvements) or tax evasion atleast. im thinking that you are still gonna be facing capital gains issues since you obviously paid one price for the place, invested a certain amount into it, then resold it later for another certain price. these prices are set in stone and changing them will require some fraudulent acts on your part. even though there was a refi in the middle, this refi pulled out cash then was paid in full within a short amount of time by another sale of the same property. this cash looks like capital gains to me since it pretty much was drawn out and not reinvested.
before you do anythign, id suggest consulting with your attorney, but im sure hes not gonna agree with your theory. but maybe, i have no clue, it just looks fishy to me.
“It will work, except that you’ll have less money available for your exchange.”
I lost you here. Perhaps you really meant that the exchanger will have less equity in the relinquished property tied up in an exchange. There is nothing to prevent the exchanger from adding cash to the deal when purchasing the replacement property.
Example: Let’s say that I have a $100K property with a $50K mortgage balance. Let’s say that I want to do a tax-deferred exchange for another $100K property that I want to purchase with 80% financing. If I do the exchange, with a new 80% LTV loan on the replacement property, there will be $30K left on the table. That $30K is now taxable (“cash boot” in exchange jargon).
If instead, I refinance the property I wish to relinquish with a new 75% LTV loan, I have just converted $25K in equity to cash. Since this is borrowed money that must be repaid, this $25K is not taxable income. I now have a $100K property with a $75K loan balance. I now complete the exchange, selling the relinquished property and purchasing the replacement property. From the $100K sale proceeds on the relinquished property, the settlement agent will pay off the $75K loan, deduct closing costs which come to $7500, and forward the net proceeds of $17500 to my exchange escrow agent. At the replacement property settlement I need $20K for the downpayment and another $5K for closing costs – but there is only $17500 cash in my exchange escrow account. Since I must contribute $7500 cash out of pocket to complete the replacement property purchase, I just add $7500 cash to the exchange escrow account.
Now my tax-deferred exchange is completed, and I have $17500 cash in hand left over from the earlier refinance. Since this came from borrowed money that was repaid, this $17500 is still not taxable income.
It depends upon how the “remodel” is characterized: as either a capital expenditure or as operating expenses, maintenance expenses in the normal course of business.
Please understand I am not an attorney nor a CPA.
When you do a remodeling project, the work is treated as a whole, not as the individual parts or actions. Actions which would normally be expensed as a normal business expense can not be treated that way. They must be rolled up into the total as a capital expenditure. As such, they must be added to the basis of the property and depreciated over many years.
Re: Anything wrong with this? - Posted by Michigan Andy
Posted by Michigan Andy on June 30, 2002 at 20:57:29:
Sorry, misread the post, and I’m gonna (weakly) blame it on a head full of sweat and sawdust.
You are right, Jeff. The basis and sales price don’t change the result of the gain (and the taxes thereon)
Can he pull the cash out of his equity before the sale? I believe so, but this doesn’t indicate any type of loan fraud, in my opinion, and his basis doesn’t change, and therefore his tax consequences don’t change (either paid now or deferred).
Who suggested anything about repairs?
What I think Ed was thinking is that he may only be taxed on the cash-out at close, therefore maybe trying to increase his LTV to lower that amount. The LTV has nothing to do with your tax consequence whether you refi once or 1,000 times.
Again, I reserve the right to be incorrect, but may have simply not gotten my point across well. I do not consider myself dangerous, nor a yahoo.
You know… (JHyre please step in) - Posted by Michigan Andy
Posted by Michigan Andy on June 30, 2002 at 14:48:10:
I have a partner who I had to thoroughly convince that it is okay to take a loss year after year on taxes. In fact, Investment Real Estate is the ONLY business that you can lose money (hopefully just paper losses) from day one the business until the day you’re dead.
I’m glad you stated that you have no clue, Jeff, as you are correct and you spared me saying it. What Ed is proposing is not tax evasion, but rather tax avoidance. Not only is it NOT illegal, it is his and every other American’s responsibility to pay as little tax as possible (Geez, isn’t that how our country started?).
Ed can do a cash out refi and blow the cash in a Tahitian casino, if that’s what he wants to do, subject to his lender’s approval for refi. Just because he pulls cash out, doesn’t change the basis for his property.
I am no expert on tax matters (JHyre is - seek his counsel), but the sale price minus his basis (or adjusted basis) is what he is taxed on, unless he chooses to place the property in a tax-deferred exchange. That is my understanding, and I’m open to corrections. I have seen what he is proposing done before, and there is nothing evasive or fishy about it. I reserve the right to be wrong.
so your saying that i can avoid ever paying ANy capital gains taxes by refinancing every peice of property that i ever hope to own the day before the sale is to happen to my end buyer? i simply cash out my equity in a refi up to the point of the sale price and then sale it for the exact amonut to pay off the mortgages agasint the property. and i can do this everyday of my life until i die and the IRS dont care? they never collect any taxes on any of my sales since i never made any money on any of the sales. and this is totally legal? they dont care about the 45 cash outs nia a row in a matter of a year as long as the banks dont have a seasoning issue mi good to go? i can do this and claim zero income for the year and opay zero taxes and claim low income tax credit on my zero income and apply for food stamps because i havent made any money in 30 years according to my sales events?
this may be legal, but i somehow doubt it. if this is the case i will never pay any more taxes till the day i die and then draw welfare and never buy my own food either. this seems totally flawed to me. this is exactly what this guy is proposing on a larger scale. the scale shouldnt matter if the deal is legal from the beginning on the first one.
id like for an attorney to answer this so i know how to plan my future investing career.
i know i blowed it way out of proportion, but this seems to me what is being suggested here.
Posted by Joe Eckburg on June 30, 2002 at 16:04:47:
The refi has nothing to do with a 1031 exchange.
Please read up on 1031 exchanges.
In a nutshell, as long as a property is held as an investment, you can “exchange” the property for a “like-kind” investment of equal or greater value (it can be more than one property), and defer (not evade or avoid) the taxes until that property (or properties) is sold. This can be repeat
yes, that is corrrect and i do know this much, but the question was about the refi before the exchange. is it tax free cash once the sale is done a short time after the refi. and is it repeatable 100 times a year with no downfalls?
i am familiar with the 1031 and know that refi has nothing to do with it, but if the refi is added to the mix, what happens now?
The important item is your basis in the property (your costs less any depreciation) If you borrow an amount that is over your basis you will be taxed on the difference as boot in a 1031. Please see an accountant who is familiar with 1031’s and stay away from these yahooos who have just enough knowledge to be dangerous.
thanks tom. this is what i was thinking. i was fairly sure that there was no way the IRS would allow you to pull out tax free cash on an investment and never claim it as any type of income.
i wasnt positive of that fact, but i knew there was a stop to this somehow. as i stated previously, i have never done a 1031 but i know the government wont allow anyone to cheat them out of taxes.
even on a 1031, they get their taxes when you cash out at the end of the deal or the next one, or whenever yuo pul out some cash in the future on your new investment properties. all your 1031 accomplishes is delaying the tax payment until a later date.
Borrowed money is not taxable income. The IRS does not care whether you finance the purchase of a property (borrow the money) or use your own cash out of pocket to purchase free and clear.
The IRS only taxes your profit on the sale of the property – the difference between your cost basis and your sale price after selling expenses. Your cost basis is what you paid for the property, plus the cost of any capital improvements, minus depreciation. Your cost basis does not change simply because you mortgage the property.
The amount of any existing loan on the property must eventually be repaid in full regardless of the seller’s actual sale proceeds. Refinancing a property for as much cash as you can take out, then selling the property for the mortgage balance will still result in a taxable event if your cost basis is less than your sale price.
Doing a cash out refinance on a property you do not sell does not create taxable income either. As long as borrowed money has to be repaid, borrowing money is not a taxable event.
Please understand that I am not an attorney nor a CPA.
I think you are pretty much correct.
However, the IRS does not like people to pull out tax-free loan money about the same time that they do a 1031 exchange.
I believe if you check that you will see that the IRS does consider that a taxable event. They treat the borrowing and the exchange of the property as one transaction and thus declare that the cash you got out was due to the “sale” and thus is taxable. This will be true whether the cash out comes before the exchange or after the exchange.
If there is enough time between the exchange and the borrowing, the IRS will not treat them as part of the same transaction. Please do not ask me how long is “enough time.” I do not know.