tax implications of cash-out refi - Posted by Kathy

Real Estate Investing Real Estate Financing
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Posted by JHyre in Ohio on February 16, 2002 at 15:05:00:

Had to go back to my notes…I thought there was caselaw (Tufts & Crane, respectively) that meant non-recourse is taxable when issued. I was wrong…here’s the scoop:

  1. If acquisition indebtedness exceeds FMV of property “by an unreasonable amount” and is non-recourse, the property’s basis = FMV and NOT it’s “cost”.

  2. Upon sale, the amount realized = the greater of FMV or the FMV of anything received + remaining principal of non-recourse debt.

  3. Your Section 108 comments are well taken.

Bottom line, issuance of the debt is NOT taxable, per your post, but reduced basis and/or increased gain may result where nonrecourse debt exceeds FMV of property.

Nice catch.

John Hyre

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tax implications of cash-out refi - Posted by Kathy

Posted by Kathy on February 15, 2002 at 10:54:08:

Does anyone know what the tax implications are for refinancing a rental for cash out? Do you treat the cash out as income? Pay capital gains on it? Or, does the whole thing not matter until you actually sell the property?

Thanks for any assistance!

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Re: tax implications of cash-out refi - Posted by Dan

Posted by Dan on February 16, 2002 at 18:14:20:

Kathy … I am going through this situation right now. I bought a property 3 years ago for 53,000 … took out a second for 25,000 a year later. I sold the property for 90,000 and my proceeds from sale are around 15,000. I didn’t have to pay any tax on the 25,000 second at the time I received it but would have to pay capital gains tax on all of the profit on the sale … but because I am doing a 1031 exchange I only have to use the proceeds from the sale provided I maintain the same debt. So I was essentially able to put 25,000 in my pocket without paying ANY tax.

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Re: Amount above basis might be taxed - Posted by Kazuko Yoshida

Posted by Kazuko Yoshida on February 15, 2002 at 18:36:24:

Dr. David Schumacher says in his book,“Buy and Hold:7 Steps to a Real Estate Fortune”,
… One of the main advantages to refinancing is that you can take out a loan for more than the original morgage or purchase price. Say you purchased a property five years ago for $200,000 and took out a $120,000 loan. Now you want to refinance because the value has risen to $320,000. So you visit your lender and obtain a loan for $220,000. Because you are now $20,000 above the basis, or purchase price, you have to pay tax on it because it’s added income. Before the Tax Reform Act of 1986, you didn’t have to pay tax on the amount that was over basis. Consult your tax accountant for validity. (p.289)

If you have increased the property value by remodeling or add-on,it should be added to the basis, I think.
Good Luck.

Kazuko (CO)

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Re: tax implications of cash-out refi - Posted by Tom (WA)

Posted by Tom (WA) on February 15, 2002 at 11:27:40:

Kathy,

Borrowing is not a “taxable event” so there will be no taxes to pay at this time.

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Amount above basis might be taxed??? - Posted by Dave T

Posted by Dave T on February 15, 2002 at 19:54:24:

Not sure that your source reference is correct. Borrowed money is not taxable, and the simple act of borrowing money does not create a taxable event, until the debt is forgiven.

The interest paid on home equity or home acquisition debt, however, has limits on the amount that may be claimed as a deduction for home mortgage interest when itemizing deductions. The rules apply mainly to cash out refinances and home equity loans.

As I read the rules, the interest paid on the smaller of:

  1. The first $100K received in a cash out refinance or home equity loan, provided the aggregate debt does not exceed the FMV of the property(ies) securing the debt, or,

  2. The interest paid on the difference between the current mortgage balance and the FMV of the property(ies) securing the debt, when the total new debt exceeds the property(ies) FMV.

To me, this means that only the interest paid on the first 100% of those 125% refinance loans is an eligible mortgage interest deduction, or, the interest on new debt that is no greater than $100K more than the prior mortgage balance – whichever is smaller.

A mortgage interest deduction is generally not allowed on that portion of the debt that exceeds these parameters, though there are some specific exceptions to this rule.

Perhaps one of the tax experts that frequent this newsgroup will clarify this for us.

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Re: Amount above basis might be taxed??? - Posted by JHyre in Ohio

Posted by JHyre in Ohio on February 16, 2002 at 08:00:08:

Borrowed money is RARELY taxable. One exception: If the refi is non-recourse, proceeds above FMV may be treated as cash profit, because there is no enforcable obligation to pay it back.

John Hyre

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Rebates? For further Confusion! - Posted by NCPaul

Posted by NCPaul on February 15, 2002 at 20:53:02:

I have a question about rebates, specifically larger ones that could attract attention. Is there a problem if say you buy a property-negotiated price is lower than market value-and due to good credit and a high LTV you are able to negotiate a rebate from the seller. For example you have a purchase price of 70k, but you borrow 90k, and the seller returns the difference of 20k after closing. How is this handled? (Tax wise?)

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Re: Amount above basis might be taxed??? - Posted by Dave T

Posted by Dave T on February 16, 2002 at 13:35:19:

John,

I would usually defer to your expertise, but I feel that your response here requires some clarification (qualification?), for me anyway.

Doesn’t the exception you note only apply to Qualified Real Property Business Indebtedness AND only to the amount of debt discharged (forgiven)?

If so, then if the taxpayer has sufficient equity in business real property to absorb the reduction, the taxpayer can elect to exclude the amount of the discharge that exceeds the FMV of the property securing the debt from gross income (IRC 108). The amount of the discharge that reduces the indebtedness below the FMV of the property securing the debt is treated as taxable income.

The amount of debt discharge so excluded then reduces the taxpayer’s basis of business real property held by the taxpayer at the beginning of the tax year following the tax year in which the discharge occurs (IRC 1017).

If you agree with this assessment, then I still stand by my original assertion that borrowed money is not taxable until the debt is forgiven.

If you disagree, please set me on the right track.

Thanks,
Dave T

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Re: Rebates? For further Confusion! - Posted by Dave T

Posted by Dave T on February 15, 2002 at 22:28:44:

Not sure exactly how the seller will be legally obligated to give you a rebate in your scenario. If you have a contract for $70K, then the settlement attorney will only give the seller his net from a $70K sale price.

If you are fortunate enough to find a lender that will lend you $90K on a $70K purchase contract, then the settlement attorney gives you anything left on the table after the seller gets his $70K (less selling and closing costs, and mortgage payoff). I have seen ads from DiTech that offer a 125% purchase money loan program for owner occupants. As I said in my earlier post, borrowed money that has to be repaid is not income for tax purposes.

If, in this example, the property does not actually appraise for at least $90K, then the mortgage interest paid on the loan amount that exceeds the FMV of the property is not deductible as a home mortgage interest expense on your Schedule A.

Now, let’s attempt to answer the question you asked. Let’s say that you contract to purchase the property for a contract price of $90K. An independent appraisal confirms that the FMV of your property is high enough to satisfy a lender who subsequently approves your loan application to purchase the property.

You hire a building inspector to inspect the property prior to settlement. The building inspector uncovers some hidden defects that he estimates will cost $20K to fix. You ask the seller to make the identified repairs prior to settlement, but the seller counters with an offer to give you a $20K repair concession at settlement. You put this in an addendum to your contract, and the lender (with full knowledge of this arrangement) still approves your original loan application. Unless the lender has directed that the repair funds be held in escrow until repairs are completed, this $20K is given to you at the settlement table.

There is no taxable income here, but your $90K cost basis is now reduced by $20K, and is now $70K. If you turn around and sell the property “as is” to someone else for $90K, then you will have a taxable profit of $20K. If, instead, you spend all $20K in capital improvements, then your cost basis is increased from $70K to $90K.

Let’s use another scenario where you might get $20K back from the seller. Let’s say that your purchase contract with the seller calls for $90K seller financing. You go to settlement and give the seller a promissory note for $90K secured by a mortgage on the property. A week later, the seller calls you up and says that he needs a chunk of money for an unexpected emergency. The seller offers to accept $70K cash as full payoff for your $90K note. You refinance the property with a conventional lender for $70K and payoff your original note. This $20K discount is taxable income (debt forgiven), while your original cost basis in the property stays unchanged. Even if you refinance for $90K and only use $70K to payoff your discounted note, you still have $20K of forgiven debt that is taxable income.

Other scenarios that involve double contracts, a shadow second mortgage, or a strawman to provide you with a $20K “rebate” might be alleged to be loan fraud. Regardless of the implication of loan fraud, forgiven debt (shadow second mortgage) is taxable as ordinary income.

A true rebate is a return of principle and reduces your cost basis. It is not taxable as income, but instead, increases your taxable profit when you sell the property.

Again, I am not a tax professional and don’t pretend to be an expert. This post only reflects my opinion.