Payoff loan before 1031 - any problem?

Question

Hi, folks, long time lurker first time posting :)

Long complicated story short (I'll elaborate if anyone wants to hear later in thread), I may need to pay off the loan on a rental property I am selling to exchange.

Would there be any issue or disadvantage in doing that?

Once everything gets done, I plan to get a loan on the new property, close to the amount of loan I am paying off on the property I am selling. I know it sounds kind of silly... but would love to hear what you think.

Thanks!!

Dave Foster · Answer

@Nori K., You're right.  Paying off the property immediately prior to a sale is not a problem.  I think the plan your lender is advancing could be right for you.  If you do a 1031 and want to defer all tax you must purchase at least as much as you sell.  So in order to get full tax deferral you'd have to deal with debt replacement on that.  So getting rid of it ahead of time will definitely help you navigate the wilderness of lending.   This way you'r reinvestment target and cash available will be the same.  So you can complete the 1031 and also get the cash out refi on B.  Once the dust settles then you can always do a refi on the new 1031 property and recoup what you put into the old property to pay it off.

Good plan

Dave Foster · Answer

@Nori K. Whew :)

Noi K. · Answer

I shouldn't have asked this question in the same thread, but these were more "what if" questions on a different property. Sorry for confusion...

I have another property (Let's call it C). Because I am in the process of working with a lender (regarding the properties A and B that I asked about in the opening post), I am working on a rate and term refi on C.

A - I am selling and potentially exchanging.

B - I am doing a cashout refi and keeping the property.

C - I am doing a rate and term refi and keeping it for now. But lately thinking maybe I want to sell/exchange later this year. Nothing is decided but I just wanted to know what the potential pitfalls are.

Hope this clears it up. Your answers were definitely helpful - thanks!!

Dave Foster · Answer

Good thing you asked @Nori K..  I thought you were talking about paying off a property before you sell it and do a 1031.  That is fine.  But I would not recommend that you refinance a property in any way right before you sell it and do a 1031.  The IRS is consistently very suspicious of that as a way for you to inappropriately access profit.

1. No

2. A refi like that does not simply put the refi proceeds at risk.  It puts your entire 1031 exchange at risk.

3. Using the refi as your normal business practice to purchase additional real estate is one of the defenses if it is called into question.  It's not that you have to purchase more than you refi.  It's that you routinely refi properties as part of your business practice to purchase other properties.  So you can demonstrate that your refi was definitely not an attempt to circumvent the 1031.

And if you're buying property anyway I'm wondering why go through the cost of a refi right before you sell if you could have waited for just a bit and then use the cash proceeds from the 1031 to purchase the new property?

Noi K. · Answer

@Dave Foster I have further questions... I may be thinking too much, but my inquring mind wants to know...

1) Rate & Term Refi is fine, even right before 1031?

2) If you cashout refi right before 1031 (say $100,000) the worst case is that you get taxed on $100,000?

3) Even if you did cashout, will it make it ok IF you put all proceeds in, buy the new property that is at least $100,000 more than the net sales price of the old one?

Noi K. · Answer

@Dave Foster Thank you!!

Since I found this forum and started learning about 1031, I've reading your posts. So very helpful :)

Yeah the idea sounded weird at first, but it may work well for me (aside from my broker making extra commissions for his good idea). Definitely adds flexibility. Thanks again!

Noi K. · Answer

Thanks for your reply, Edward.

Yeah if I have a better option, I wouldn't think of this. But here's why -

The property (A) I am selling has big negative cashflow, which is pushing up my DTI and thus preventing me from doing a cashout refi on another bigger property (B).

My mortgage broker has been working on the numbers, and one way he came up with is to deal with A and B at the same time. We'd cashout from B and payoff A with part of the refi cash. That way A's DTI problem is eliminated and I can cash out from B.

Originally I was just thinking to sell A, so it wasn't a big question. But now I am inclined to use 1031 exchange instead. I know that cashout refi too close to the exchange is no good, but putting more money into the property should be no problem for the IRS. More of my money will be locked in until I can get it out again as a loan, but that's another problem.

Edward Liu · Answer

This does not sound like the right thing to do with your money, at least not very clear of benefit.

When you sell a property, at close, closing agent will pay off the mortgage as part of the close.  Rest of the proceeds go to 1031 intermediate entity.  (I just sold a building last week and proceeds are in 1031 exchange).  When you purchase other properties and needs distribution, you need to request the money.

If you pay off loan first, then you have much more proceeds locked into 1031.  There is no additional benefit for all these cash to sit there.  You might as well keep your cash in your own bank and do whatever you want with the money.

Payoff loan before 1031 - any problem?

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