﻿1031 Exchange Vs. Cash Out Refi: Today, I’m going to help you figure out Which one Is Best For You.
And be sure to stick around until the end where I’ll answer the most frequently asked questions
regarding these strategies. ________________
I’m Tyler Cauble and welcome back to my channel where each week we’re sharing commercial real
estate investing strategies, leasing & management tips, market updates and more.
If you’re anything like me, you’re constantly evaluating your real estate
portfolio to determine if your equity is being utilized to its best potential.
And that means exploring all options to see if you might be able pull out
that equity and place it somewhere else so that you can get a better return.
There are really only two ways that you can realize this equity in any of your investments:
either you sell the property or you perform a cash out refinance.
But which is better for you: selling your property and performing a 1031 exchange or refinancing the
project and pulling your cash out? First, What Is A 1031 Exchange?
________________ In short, the 1031 like-kind exchange
is derived from the Internal Revenue Service’s 1031 tax code, which allows any property held
for business or investment purposes to be sold and the proceeds exchanged into another property
without having to pay capital gains taxes. That is to say, this code allows you to retain
all of the profits when you sell a property and then re-invest them into a property of equal or
greater value, as long as you locate and purchase the new property within a certain time frame.
If You want to Take a deeper dive into 1031 exchanges, check out this video here.
And What Is A Cash Out Refinance? ________________
A cash out refinance is similar to a traditional refi, whereby you place new
debt on the property and pay off the old loan. However, if you’ve created enough equity in the
property through value-add or have held it long enough to build up an equity position,
you can actually take on a larger loan, so long as the debt service coverage ratio doesn’t dip below
1.2 or so, meaning you will actually take out more cash from the new loan than you originally
put into the property. Pretty neat, right?
This cash that you “pull out” from the property is considered a loan,
so it’s completely tax free, and you’re welcome to spend it on anything you want
(hopefully, more real estate investments!) Which Is Better: 1031 Exchange Or Cash Out Refi?
________________ Well, just like everything
in commercial real estate: it depends. Before you can really determine which
path is best for you, you should ask yourself the following questions:
What Are The Pros and Cons of each option? Well, with a 1031 exchange, you get a
large chunk of cash and can immediately move that into a larger property - certainly a pro. However,
you no longer own the original asset, which can be seen as a con. And, if you don’t properly execute
the 1031 exchange, you could end up liable for capital gains taxes from the sale.
In a cash out refi, you will be taking out capital tax free since it’s actually a loan,
which is always nice, but you will likely be increasing your monthly debt service and
decreasing your cash flow, which could be a con. There are also fees that the lender will charge
when going through a refi, but you do get to keep the property and grow your portfo.
Next, What Are Your Long-Term Goals for this building and this location?
If you’re only looking to find the next strong investment opportunity that gives you decent cash
flow and appreciation, then you’re likely going to take the 1031 exchange route since you will have
more capital to buy a larger project elsewhere. However, if this property is in your neighborhood
and you’d like to hold on to it for a long time because of that,
you’re likely going to refinance the site so that you can continue to cash flow and hold onto it.
Your long-term goals will certainly play a factor into your decision.
What Was Your Original Intent With The Property? If your strategy was to fix a building up and flip
it for a quick profit, you likely won’t qualify for a 1031 exchange, which would (obviously)
eliminate that opportunity, altogether. If that’s the case, you’re likely utilizing the
BRRRR strategy (check this video out here) and will want to refinance the property as soon as
possible to pull out that equity you’ve created. Your original intent for the site only really
matters for the 1031 since there are more steps to properly qualifying for a like-kind exchange.
But, You Could Actually use a more advanced strategy and Do Both…
The beauty of both of these strategies is that they allow you to snowball your wealth,
so long as you keep the capital you pull out of the project in play.
Let’s say you purchase an office building, fix it up, and stabilize it with new tenants.
You’ve created quite a bit of equity in that property and now you want to pull that out.
You could execute a cash out refi, buy a shopping center, and after you’ve held that shopping
center for a while, you could sell it and 1031 exchange the proceeds into a third property.
On the flipside, if you wanted to sell that office building, you would be able to 1031
exchange those proceeds into the shopping center and immediately refinance after the closing to
pull out some of that trapped equity. Of course, none of these strategies are
quite that simple, so I recommend you consult your broker, attorney, and CPA when considering
any big financial moves. Which Do I Prefer?
I actually like to utilize the cash out refi strategy over the 1031 exchanges.
That’s because my investing strategy is a bit unique compared to most investors:
I prefer to invest as much as I can within a 15 minute radius of my office (largely East
Nashville and Madison). I also own a commercial real estate brokerage and a commercial property
management company that run my projects, so it helps when we have a concentration
of products in a manageable territory. So, I’m more of a buy and hold kind of guy,
but there’s certainly a season for each strategy and I’ve sold assets to perform a 1031 exchange
under the right circumstances. Now for the Frequently Asked Questions
________________ How Soon Can You Refinance A 1031
Exchange Property? As soon as you want!
You are permitted by the IRS code to refi the property as soon as you close on it.
Keep in mind, though, that you either need to close on the new site in cash or negotiate
with your lender to avoid pre-payment penalties so that you don’t lose any
money by refinancing the debt. How Much Can You Cash Out On A Refi?
The amount that you pull out of the project will largely depend on how much
equity you’ve built up in the property and the current monthly cash flows.
Most lenders won’t exceed around 80% LTV and prefer to see at least a 1.2x DSCR to ensure
that they don’t have to much risk in your asset. Other than that, it’s not uncommon to be able to
pull out up to 2x your original investment - or even more!
Can You Do A Cash Out Refi Then 1031 Exchange that Property?
No, you cannot! Be very careful here, because
the IRS may flag this transaction and you would lose any benefits from doing a 1031 exchange.
They interpret a cash out refi near the sale of the property as the seller “realizing”
profit , so I highly recommend having those conversations with your CPA ahead of time.
Alright, now that you know the differences between a 1031 exchange and a cash out refi,
check out this video here on how to do a 1031 exchange,
where I walk you through the steps of properly executing a like-kind exchange
and everything else you need to know during the process. I’ll see you there.