by Prince Licaylicay | Jan 7, 2022 | All Articles, Buying, Exchanges (1031 & DST), Investing, Selling
As a real estate investor, you’re likely always assessing your portfolio to ensure your investments perform well. This process often involves evaluating your real estate options to determine if you can extract value and reinvest in more profitable ventures.
You have two primary options to realize the equity in your assets: selling the property or refinancing with a cash-out. But which is the better choice for you: selling your property and performing a 1031 exchange, or refinancing and pulling out cash?
What is a 1031 Exchange?
A 1031 Exchange, also known as a like-kind exchange, allows you to swap one investment property for another. This strategy enables real estate professionals to grow and diversify their portfolios while minimizing federal income tax implications. To qualify under Section 1031, the exchange must involve real property held for productive use in trade, business, or investment.
Additionally, the new property must serve a similar purpose. This approach defers tax payments until the property acquired in the exchange is eventually sold.
What is Cash-Out Refinancing?
Cash-out refinancing replaces an old mortgage with a new one, typically with a higher loan amount. The borrower can then use the difference to access cash. This option usually provides more favorable terms, such as lower interest rates or monthly payments, and allows for debt consolidation or credit score improvement.
Advantages of a 1031 Exchange
- Low Minimum Investment: Multiple investors can pool resources, making the minimum investment on a TIC (Tenants in Common) property lower.
- Portfolio Diversification: The lower investment barrier allows you to diversify across multiple properties, reducing the risk of significant losses.
- Access to High-Quality Real Estate: Pooling funds grants access to higher-quality properties, potentially attracting higher-income tenants.
- Ease of Ownership: Shared ownership distributes day-to-day management responsibilities among multiple investors, reducing your workload.
Disadvantages of a 1031 Exchange
- Shared Risk and Rewards: Sharing risk also means sharing rewards. Rental income is divided among all investors, resulting in smaller individual shares.
- Limited Decision-Making Power: Co-ownership limits your ability to make unilateral decisions. Major decisions require a vote, which may not suit those who prefer independent control.
Advantages of Cash-Out Refinance
- Lower Interest Rates: Cash-out refinancing often offers lower interest rates, especially if current rates are lower than when the property was initially purchased.
- Debt Consolidation: You can use the cash from refinancing to pay off high-interest debts, potentially saving thousands in interest.
- Improved Credit Score: Paying off credit card debt with a cash-out refinance can boost your credit score, increasing your borrowing power.
- Tax Deductions: Mortgage interest on a cash-out refinance may be tax-deductible if used for property improvement, reducing your overall tax liability.
Disadvantages of Cash-Out Refinance
- Foreclosure Risk: Using your home as collateral means that failing to make payments could result in foreclosure. It’s crucial to ensure you can manage debt payments to avoid this risk.
- Closing Costs: The new mortgage will come with new terms and closing costs. Double-check interest rates and fees to avoid unexpected expenses.
Refinancing a 1031 Exchange Property: Before and After
Refinancing before a 1031 exchange is straightforward. The lender uses the property’s equity as collateral, and the taxpayer pulls out cash. After selling the property, the taxpayer pays off the loan and reacquires the debt on the purchase side of the exchange.
This approach allows the taxpayer to extract cash from equity without triggering tax liability, especially if the new debt has a lower interest rate than the refinance loan. However, some tax experts suggest refinancing the replacement property after the exchange. Therefore, it’s essential to consider the risks and consult your tax expert before making a decision.
Conclusion
If you’re looking to sell your property, generate income with low investment, diversify your portfolio, and share risks and rewards, a 1031 exchange might be your best option. On the other hand, if your goal is to secure lower mortgage interest rates, consolidate debt, or improve your credit score, cash-out refinancing could be the ideal choice.
Even after outlining all the information above, deciding whether to go for a 1031 Exchange or a Cash Refinancing can still seem daunting. That’s why the LeveragedCRE Investment Team at Commercial Properties, Inc. is here to help you achieve your business and investment goals. Contact us at (480) 330-8897 or send us an email at request@leveragedcre.com.
Need assistance with your 1031 Exchange or DST? We’ve got you covered!
We’ve prepared a comprehensive, free e-book designed to guide you in achieving your long-term business goals or acquiring that dream property you’ve been eyeing.
Meet The LeveragedCRE Investment Team
Phill Tomlinson and Eric Butler are seasoned commercial real estate brokers with over 44 years of combined experience. They lead the LeveragedCRE Investment Team at Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, specializing in investment sales and tenant/landlord representation across the Phoenix and Scottsdale submarkets.
The team leverages their extensive knowledge and expertise to help investors and property owners maximize their returns and navigate complex real estate transactions with confidence.
Stay informed with the latest in Commercial Real Estate strategies designed to enhance your income property investment results by bookmarking www.leveragedcre.com. Let us help you stay ahead in the market!
by Prince Licaylicay | Jan 4, 2022 | All Articles, Buying, Investing
Financing is essential for constructing, developing, and investing in commercial real estate (CRE) properties. When investors or CRE developers lack sufficient funds, they often seek CRE loans from various entities, including banks, independent lenders, insurance companies, and private investors. These loans typically have repayment terms ranging from 5 to 20 years, with an amortization period that is often longer than the loan term.
If you’re new to CRE investing or development, it’s crucial to familiarize yourself with some important terms. Below, we’ll explore key concepts that will help you navigate CRE loans with confidence.
Key Terms in CRE Loans
Loan-to-Value (LTV) Ratio
One of the first things you’ll encounter when applying for a CRE loan is the Loan-to-Value (LTV) ratio. This ratio measures the loan amount against the property’s value (loan amount ÷ property value x 100). Typically, lenders prefer loans with lower LTV ratios because they involve less risk. Therefore, a lower LTV ratio indicates that the property has a higher equity stake, which is beneficial for both the lender and the borrower.
Credit Rating and Guarantee
Another crucial aspect of CRE loans is the credit rating or financial record required by lenders. In many cases, if an applicant lacks a sufficient credit rating, the lender may request the business owner to provide their own credit history as a guarantee for the loan. However, if no guarantee is provided, the CRE property itself often serves as the only means of recovery if a loan default occurs. This type of loan, known as a non-recourse loan, limits the lender’s recourse solely to the property.
Loan Repayment Schedules
As mentioned earlier, commercial loans typically range from 5 to 20 years, with an amortization period that usually exceeds the loan term. Importantly, longer loan repayment periods generally result in higher interest rates. Consequently, it’s essential to understand how the repayment schedule will impact your overall investment strategy.
Debt-Service Coverage Ratio (DSCR)
The Debt-Service Coverage Ratio (DSCR) is a critical metric that assesses a property’s ability to cover its annual mortgage payments based on its annual net operating income (NOI). This ratio is calculated by dividing the property’s annual NOI by its annual mortgage payment (annual NOI ÷ annual mortgage payment = DSCR). Ideally, a DSCR greater than 1 indicates that the property’s cash flow is sufficient to cover its mortgage payments. Conversely, a DSCR less than 1 suggests that the property’s cash flow may not be adequate to meet its annual mortgage obligations.
Tax Implications of CRE Loans
With these loan provisions in place, CRE investors and developers still face the challenge of taxation. Understanding tax deductions can help ease these burdens, making it essential to explore how tax deductions work in the context of CRE loans.
What is a Tax Deduction?
A tax deduction reduces an individual’s or organization’s taxable income by subtracting a government-validated amount. This amount may include annual expenses that can be deducted from gross income. Governments establish tax codes to determine which items are taxable and which expenses are tax-deductible, including mortgage interest for investment properties. So, are CRE loans tax-deductible? Yes, they are, but let’s delve into how this works.
How Tax Deductibility Works
When you take out a CRE loan, the interest payments on the mortgage are considered tax-deductible. These deductions are reported on the Mortgage Interest Statement. Importantly, lenders are usually required to provide this form if the mortgaged property is considered real property.
For example, if your annual taxable income is $100,000 and your annual mortgage interest payment is $30,000, the mortgage interest payment can be claimed as a tax deduction. Consequently, this reduces your taxable income to $70,000.
Itemized vs. Standard Deductions
Tax authorities typically allow the use of either itemized deductions or standard deductions. You can choose to take a fixed standard deduction or itemize qualified expenses that are considered tax-deductible. Understanding the difference between these options can significantly impact your tax strategy.
Determining Tax-Deductible Interest
You may wonder how to determine the threshold of tax-deductible interest you can claim. This depends on your marginal tax rate, also known as your tax bracket. Essentially, the higher your income, the higher the tax rate, which directly affects the deductibility of mortgage interest.
Qualifications for Tax-Deductible Mortgage Interest
To qualify for tax-deductible mortgage interest, three conditions must be met:
- The borrower must be legally liable for the loan.
- The lender and borrower must agree that the borrower intends to repay the loan.
- A legitimate lender-borrower relationship must exist.
These provisions ensure that loans are genuine and not merely strategies to avoid or reduce income tax. Additionally, the loan must be used, not just kept in a bank. If the loan isn’t utilized, tax authorities may disallow the deduction, even if repayments are being made.
Conclusion
Taxation can be complex, especially for beginners in CRE investing. However, by understanding these basic terms and provisions, you can navigate the field of loans and taxation more confidently and make informed decisions about your CRE investments.
Even after outlining all the information above, dealing with loans when investing in CRE can still seem daunting. That’s why the LeveragedCRE Investment Team at Commercial Properties, Inc. is here to help you achieve your business and investment goals. Contact us at (480) 330-8897 or send us an email at request@leveragedcre.com.
Need assistance with your 1031 Exchange or DST? We’ve got you covered!
We’ve prepared a comprehensive, free e-book designed to guide you in achieving your long-term business goals or acquiring that dream property you’ve been eyeing.
Meet The LeveragedCRE Investment Team
Phill Tomlinson and Eric Butler are seasoned commercial real estate brokers with over 44 years of combined experience. They lead the LeveragedCRE Investment Team at Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, specializing in investment sales and tenant/landlord representation across the Phoenix and Scottsdale submarkets. The team leverages their extensive knowledge and expertise to help investors and property owners maximize their returns and navigate complex real estate transactions with confidence.
Stay informed with the latest in Commercial Real Estate strategies designed to enhance your income property investment results by bookmarking www.leveragedcre.com. Let us help you stay ahead in the market!
DISCLAIMER:
Leveraged CRE is not a law firm, and its employees are not attorneys nor are we affiliated or associated with attorneys. The information contained in this blog is general information and should not be construed as legal advice to be applied to any specific factual situation.
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