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.
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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.
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