Cash out refi affect future capital gains?

Question

When doing a cash out refi to buy more properties, how does that affect a future sale of the property that had cash pulled out? I’ve read about it being done to close to each other and I know that’s a no go. But if I do a cash out refi and then sell the property that had cash pulled out, say 2 or 3 years later what happens. If I can prove that I used the funds to buy more property would I have to pay capital gains?

Tony Hightower · Answer

If you sold, then you would be paying taxes on the gain of 100k. If you 1031, you would need to 1031 into at least a 200k property to defer all gains. Which means in 5 years you would need to pull 100k out of pocket for that exchange.

You could also do a partial exchange. Pay tax on some of the gain based on your personal tax situation. Or create more passive losses, to offset the gain.

NOT REAL ADVICE, NOT A CPA, TALK TO A GOOD ONE.

Dave Foster · Answer

@David Wild, As mentioned several times, the amount you owe does not determine your profit at all.  In the example you threw out where you bought for 100 and refied to 200 and then later sold for 200.  You are absolutely correct.  You have a gain of $100K (sales price minus your basis or what you paid for it).  It doesn't matter what cash you have.  Because a refinance does not impact your sale price or your basis.

But what your example illustrates is how the 1031 can fit into this scenario.  Let me make one small change - you bought for 100 and refinanced to 200 and then sold for 250.  Your responsibility in a 1031 is to purchase at least as much as your net sale and use all of the proceeds.  In this scenario your sales price is 200.  And you have proceeds of $50K.  But you have a gain of $150K!!!!

So you do a 1031 using the $50K in proceeds to purchase a property worth at least $200K.  And you shelter all of the $150K of gain.  It's not uncommon for our clients to come out of a sale with no cash and still do a 1031 because they have accessed the cash through a refinance.  But they still do a 1031 to defer the tax.

David Wild · Answer

I was considering pulling cash out of a few rentals to purchase another rental. I think “amount paid” may be the term I have been looking for.

Nicholas Coulter · Answer

@David Wild You will be good on the tax side since its amount paid. Are you doing this on rental properties or your primary residence?

David Wild · Answer

Yeah that’s the plan.

David Wild · Answer

I understand if it went up in value again and I sold I could use those proceeds in a 1031. But if the basis is 100k and I refi to 200k, then  sold 5 years later for let’s say 200k. I would owe tax on 100k even though that money was reinvested into another property and I wouldn’t actually be pocketing any cash?

Matt Devincenzo · Answer

@David Wild I think you're mixing apples and oranges...

Basis is purchase price (minus land value) plus upgrade costs, so your gain is sale price minus basis. That doesn't change with financing, or timing, or what you do with any possible refi proceeds.

You're alluding to using refi proceeds to purchase another rental (no issue), but implying the refi creates an issue with the possibility to 1031 later. That isn't the case except in one very specific circumstance which is where I think you're coming from. If you refi and then sell shortly after you can trigger an issue with a 1031 for a period of time. The reason being it appears you pulled out the cash to avoid having to reinvest it into your exchange. The solution is simply to ensure you don't refi for a period of time before you plan a 1031 on that property.

David Wild · Answer

So when people are using this method to acquire more properties they are giving up the tax break of doing a 1031 on any of the additional money borrowed? I assume the thought is to never sell the refinanced properties? I have a few that I was thinking about refinancing to pay cash for another one, but I’m a little hung up on the future taxes and I’m not sure the properties I have are forever keepers.

Chris Seveney · Answer

@David Wild

Amount of financing you have on a property has no basis for taxes.

It’s what you paid (and any upgrades) versus what you sold it for.

Cash out refi affect future capital gains?

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