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1031 Exchange vs. Cash Refinancing: Which Is Best For You?

by | Jan 7, 2022 | 1031 Exchange, All Articles, Buying, Investing, Selling

If you’re like most real estate investors, you’re continually assessing your portfolio to see if you are spending your money well. That involves exploring your real estate choices to determine if you can extract your value and reinvest in a more successful investment vehicle.

You may realize this equity in your assets in one of two ways: selling the property or refinancing with cash out. But which is better for you: Selling your property and performing a 1031 exchange or refinancing the project and pulling your money out?

 

What is 1031 Exchange?

A 1031 Exchange, otherwise known as a like-kind exchange, is a swap of one investment property for another.  Kind transactions allow real estate professionals to grow and diversify their portfolios, with limited federal income tax implications. To qualify under Section 1031, there must be an exchange of real property held for the productive use in a trade or business or for investment solely for property of a like-kind to be held either for practical use in a trade or business or investment. It is a mode of asset appreciation on the exchange wherein the payment of tax is not eliminated but merely deferred until a later point when the taxpayer eventually sells the property received in the exchange.

 

What is Cash Refinancing?

A cash-out refinancing refers to a mortgage financing option where an old mortgage is replaced for a new one with a more significant amount than owed on an initial load, thus helping borrowers use the difference to procure some cash. In real estate, financing generally refers to replacing an existing mortgage for a new one that typically extends more favorable terms to the borrower. By refinancing a mortgage with a new one, you may be able to have potential access to cash, decrease the monthly mortgage payments, negotiate a lower interest rate, renegotiate the periodic loan terms, remove or add borrowers from the loan obligation.

 

Advantages of a 1031 Exchange

  1. Low minimum investment and flexible investment amounts. Because multiple people are investing in the same asset, the minimal investment on a TIC property is usually lower than you might expect. In addition, since tenants own the property in a shared ownership agreement, each owner can maintain a different interest in the property. Moreover, the amount you can expect depends wholly on the size of your ownership, i.e., the larger the size of property owned, the larger the return and vice versa.
  2. Higher potential for diversification and safety. Given that the safety barrier to the investment is lower in a TIC property, this fact offers many investors the chance to diversify their portfolios and invest in multiple properties. This, as a consequence, makes each investment secure since it lessens the likelihood of incurring significant losses.
  3. Access to higher-quality real estate. Since people tend to pool their money for investment purposes, the TIC investor often has access to higher quality real estate than they would afford if they invest in the same using their own money. This also opens up an opportunity to attract tenants with higher levels of income.
  4. Greater ease of ownership. Since the property has multiple owners, it means that there will be various hands that would be able to take care of the day-to-day operations and the management of the investment property. So while you may be able to pull your weight investment-wise, the amount of work you are expected to do is less than the work you will do if you own the property on your own.

 

Disadvantages of a 1031 Exchange

  1. Shared risk means shared rewards. It should be noted that sharing a portion of the risk for investment purposes also requires you to share any rewards from it as well. For example, the portion of any rental income you receive will only be a portion of the whole, which is smaller than what you would usually receive if you were the sole investor. The reason behind this is that whatever profit you might earn is shared with your co-investors.
  2. Little potential for unilateral decision-making. Undoubtedly, having co-owners also takes away your right to make unilateral decisions regarding the property. In addition, the IRS Revenue Ruling 2002-22 provides that a vote must take place before any major decisions may be made. Therefore, if you are not the type of person who does well in group decision-making, this type of investment may not be for you.

 

Advantages of Cash-out Refinance

  1. Lower interest rates. A mortgage refinances usually offers a lower interest rate than a home equity line credit/home equity loan. A cash-out might give you a lower interest rate down the line, especially if you would have bought your property when mortgage rates were much higher.
  2. Debt consolidation. Utilizing the money from a cash-out refinance to pay off interest-bearing loans that give high interest could save you thousands of dollars of interest. This is because Cash-out refinancing typically offers lower interest rates than you would have paid if you bought the property.
  3. Higher credit score. Paying off your credit card in full due to a cash-out refinance will eventually build a positive credit score from the banks where you procured the loan. This reduces the credit rationalization ratio, i.e., that ratio the banks use to determine whether to lend you money or not, as well as the amount of credit available for you to use. Therefore, the higher the credit rating, the more money the banks are willing to lend you.
  4. Tax deductions. Mortgage interests may be utilized as a deduction to the total amount of tax you will pay. In addition, this interest may be available on a cash-out refinance if the money will be used for the purchase, building, or the substantial improvement of your home. All of these interest expenses may be deducted from the total amount of tax due, which will benefit the taxpayer.

 

Disadvantages of Cash-out Refinance

  1. Foreclosure risk. There is a foreclosure risk because your home is used as collateral for the mortgage. There is, therefore, a risk of losing your home if you cannot make prompt payments. Therefore, if you are doing a cash-out refinancing, always make sure that you are promptly paying your credit-card debt; otherwise, you run the risk of the possibility of losing your home because of the non-payment of the debt in due time.
  2. Closing costs. The new mortgage will have different terms from the original loan. So, always make sure that the interest rates and fees are double-checked before agreeing to further terms and conditions. Otherwise, you will be exposed to risk because of ambiguous, extravagant closing costs that you could not take note of before closing the agreement or agreeing to new terms.

 

Refinancing a 1031 Exchange Property: Before and After

The mechanics of refinancing in 1031 transactions before exchange are relatively simple. The taxpayer pulls cash out of the relinquished property from a lender. This lender uses the equity in the property as collateral. Then, the taxpayer sells the property, pays off the loan, and then reacquires the debt on the purchase side of the exchange. The debt must be reacquired; otherwise, the taxpayer will have to pay tax on the cancellation of the debt. If the aforementioned process goes down without a hitch, the financial advantage is this: The taxpayer has pulled cash from his equity without triggering any tax liability. This will be even more advantageous if the new debt on the purchase has a lower interest rate than the refinance loan.

Furthermore, some tax experts feel that refinancing the replacement property after the exchange is preferable to refinancing the relinquished property before the exchange. In any case, you should think about the dangers and talk to your tax expert about your objectives.

 

CONCLUSION: If you want to sell your property and generate income with a low minimum investment and flexible investment amounts, or if you’re going to have a higher potential for diversification and safety, but shared risk means shared rewards, or if you’re going to have a limited ability to make unilateral decisions, then a 1031 exchange is for you. On the other hand, cash-out refinancing is the most fantastic option if you desire lower mortgage interest rates, the chance to combine your debt or a good credit rating.

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 Leveraged CRE 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 help on your 1031 Exchange? We got you covered! We prepared a free e-book that will serve as your guide to achieve your long-term business goals or obtain that property you’ve always been dreaming of!
1031 Exchange

 

Phill Tomlinson is a commercial real estate broker with Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, and owner of the Leveraged CRE Investment Team specializing in investment sales and tenant/landlord representation in the Phoenix and Scottsdale submarkets. Phill applies over 21 years of experience in the Real Estate industry helping investors and owners maximize their returns.

 

Bookmark www.leveragedcre.com to learn more about the Commercial Real Estate market and keep informed of relevant real estate strategies designed to maximize your income property investment results. Connect and follow Phill on Social Media at sm.leveragedcre.com/smplatform. #LeveragedCRE

 

 

Are CRE Loans Tax-Deductible?

by | Jan 4, 2022 | All Articles, Buying, Investing

The construction, development, and investment in commercial real estate (CRE) properties require financing. If an investor or a CRE developer lacks or is short in funding, they typically apply for CRE loans from numerous entities providing these loans, such as banks, independent lenders, insurance companies, and private investors. These loans typically entail five (5) to 20-year repayment terms, with the amortization timeframe longer than the loan term.

If you are new to CRE investing or development, here are some important terms you need to familiarize yourself with.

 

Loan-to-Value (LTV) Ratio

One consideration for CRE loans is the percentage of the loan-to-value (LTV) ratio, or the loan value measured against the property value (loan value ÷ property value x 100). Lenders favor loans with lesser LTV since these properties sustain higher stakes and, therefore, involve lesser risks.

 

Credit Rating and Guarantee

For almost every loan provision process, a financial record or credit rating is required of entities or individuals applying for such loans. In cases where these entities lack financial record or credit rating, the lender may require the owners of the business entity to utilize their own financial track record/credit rating, therefore providing guarantee for the loan. If the guarantee is not provided, the CRE property subject for construction/development is often identified as the only means of recovery when a loan default happens. This mechanism is referred to as a non-recourse loan.

 

Loan Repayment Schedules

As mentioned, commercial loans can range from five (5) to 20 years, and the amortization timeframe would typically be longer than this loan term. In this matter, a longer loan repayment timeframe equates to higher interest rates.

 

Debt-Service Coverage Ratio

Debt-service Coverage Ratio (DSCR) refers to the ability of a property to pay its annual mortgage fee based on its annual net operating income (NOI). This is calculated by dividing the property’s annual NOI with its annual mortgage fee (annual NOI ÷ annual mortgage rate = DSCR) to determine whether the cash flow can cover the fee. The DSCR must be more than 1, less from which indicates that the ratio is negative, implying that the annual cash flow is not enough to cover the property’s annual mortgage fees.

With all these loan provisions in place, CRE investors and developers still must deal with taxation. It is understandable why CRE investors and developers are in search of ways to ease these burdens. So, one thing to look at is tax deduction.

 

Now, the question: are CRE loans tax-deductible?

Let’s first get to know what tax deduction means. A tax deduction is the process of reducing an individual or organization’s tax liability by subtracting a government-validated amount from their taxable income. This government-validated amount may include annual expenses that can be deducted from an individual or organization’s gross income. Governments set tax codes to determine taxable items and tax-deductible expenses, and these include mortgage interest for investment properties. So, to answer the question: yes, CRE loans are tax-deductible. However, in this article, we look at this from a slightly different perspective.

 

How does this work?

An individual or business entity pays their taxes, the amount of which is determined by their annual taxable income. The higher their taxable income is, the higher their tax rate will be. Therefore, the goal is to reduce the annual taxable income.

If a person or a business entity applies for a CRE loan, the interest payments for mortgage are considered tax deductibles, or qualified reductions on an individual or organization’s income tax return. This is to be reported on the Mortgage Interest Statement. Lenders are typically required to supply this form to borrowers in the event that the property subject to mortgage is considered a real property, or a piece of land and all structures within its premises.

What happens is while you pay your full mortgage every month, this amount is tax-deductible and can still be used to deduct from your taxable income, thus reducing it. Therefore, your interest mortgage payments allow you to save a certain amount from your taxes.

For instance, your initial annual taxable income is at $100,000 and your annual mortgage interest payment is at $30,000. Your mortgage interest payment, which can be claimed as tax deduction, can be subtracted from your annual taxable income, which will then be reduced to only $70,000.

Typically, tax authorities only allow the utilization of either itemized deductions or standard deductions. This means that an individual or an organization can only choose whether to opt for their standard deductions – a fixed deduction amount you are qualified for – or for itemized deductions, which entails the enumeration of government-validated and qualified expenses which are considered tax deductibles.

 

Tax-deductible interest threshold

Perhaps you are wondering: how can you determine the threshold of tax-deductible interest you can avail? What/who determines this?

The answer depends on your marginal tax rate, or also referred to as your tax bracket. This is the pre-determined income tax rate based on your income. This moves as your income increases or decreases, or simply put: the higher your income is, the higher tax is deducted from you.

Now, what are the qualifications for your mortgage interest payments to be tax deductibles?

There are typically three (3) qualifications for your mortgage interest payments to be considered as tax deductibles. First, the borrower must be legally liable for the loan applied. Next, the lender and the borrower must both agree that the latter intends to repay the loan. Finally, the lender and the borrower are required to form a legit lender-borrower relationship.

All these provisions mean that you must be viable for a loan and this should be between you and a legit lender, not just from relatives or friends. Otherwise, your loan interest might not be considered deductible by tax authorities. This is because tax authorities want to secure that these loans are not only strategies for people to avoid or reduce their active income tax.

In addition, you are required to spend your loan and not just let it sit in a bank. If this happens, tax authorities will also not consider your loan repayment as deductible, even if you are actively repaying what you owe your lender.

Indeed, taxation can be complex if you are a beginner in the area but these pieces of information may now allow you to enter the loan and taxation field with the basic knowledge on how terms work.

Even after outlining all the information above, dealing with loans when investing in CRE can still seem daunting. That’s why the Leveraged CRE 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 help on how to get started investing in commercial real estate? We got you covered! We prepared a free e-book that will serve as your guide to achieve your long-term business goals or obtain that property you’ve always been dreaming of!

 

Phill Tomlinson is a commercial real estate broker with Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, and owner of the Leveraged CRE Investment Team specializing in investment sales and tenant/landlord representation in the Phoenix and Scottsdale submarkets. Phill applies over 21 years of experience in the Real Estate industry helping investors and owners maximize their returns.

 

Bookmark www.leveragedcre.com to learn more about the Commercial Real Estate market and keep informed of relevant real estate strategies designed to maximize your income property investment results. Connect and follow Phill on Social Media at sm.leveragedcre.com/smplatform. #LeveragedCRE

 

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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