Investing in real estate can provide significant tax advantages. But, selling an investment property can trigger a large capital gains tax bill. If you want to tap the equity in a property, these taxes could dissuade you from selling. Fortunately, cash-out refinances act as an alternative, allowing investors to both A) convert available equity into cash, and B) avoid capital gains taxes. As such, we’ll use this article to explain how to use a cash-out refinance to avoid capital gains taxes.
Specifically, we’ll cover the following topics:
- Capital Gains Tax Overview
- Using a Cash-out Refinance to Avoid Capital Gains Taxes
- Additional Tax Considerations to a Cash-out Refinance
- Final Thoughts
Capital Gains Tax Overview
When you sell a capital asset (e.g. an investment property) for more than you purchased it, you are said to have realized a capital gain. As with most gains, the IRS wants to collect its cut. Accordingly, investors typically need to pay a capital gains tax on these gains. Depending on your income bracket (and assuming you’ve owned the property for more than a year), the IRS taxes capital gains at a rate of 0%, 15%, or 20%.
When you purchase an investment property, that acquisition cost typically represents your taxable basis, that is, the amount used to calculate future capital gains. If you spend money improving the property before leasing it, those improvement costs will also increase your taxable basis.
A Capital Gains Example
For example, say you purchase a vacant office building for $1,000,000. Before leasing it, you spend another $250,000 improving the building. Therefore, when you lease the property post-renovation, you will have a taxable basis of $1,250,000 ($1,000,000 acquisition cost plus $250,000 in renovations).
After leasing the building for five years, you decide to sell. Ignoring transaction costs, a $2,000,000 sales price would translate to $750,000 in capital gains ($2,000,000 sales price minus $1,250,000 taxable basis). At a 20% long-term capital gains rate, this gain would translate to a $150,000 capital gains tax ($750,000 in capital gains times 20% rate).
NOTE: The above example ignores the tax effects of depreciation recapture.
Using a Cash-out Refinance to Avoid Capital Gains Taxes
Let’s say you want to avoid that $150,000 tax bill. But, you also want to convert some of your increased equity into cash. Enter the cash-out refinance. In simple terms, a cash-out refinance replaces your old mortgage with a new, larger loan, and you pocket the difference as cash.
In addition to providing you access to cash, this cash-out refinance offers a huge tax benefit. Namely, the IRS doesn’t treat proceeds from a cash-out refinance as income. Instead of selling your property and triggering a capital gains tax, you secure a larger loan, pay off the old mortgage, and take out the difference as cash.
This system lets you A) convert an investment property’s equity into cash, while B) avoiding capital gains taxes.
A Cash-out Refinance Example
Continuing the above example, let’s say that you have a $500,000 outstanding mortgage on your property at the five-year mark. And, a recent appraisal has confirmed that the property has a $2,000,000 valuation. Now, assume that your lender offers a cash-out refinance product up to 70% loan-to-value (a common standard with commercial refinances). This means you will qualify for a new loan of $1,400,000 ($2,000,000 value times 70% LTV).
Ignoring transaction costs for simplicity’s sake, a portion of this new mortgage must pay off the old loan. This leaves you with $900,000 ($1,400,000 new loan minus $500,000 payoff of old loan). In other words, you’ve just accessed $900,000 in cash, and you don’t need to pay any taxes on it. Of course, you will need to make monthly payments on a significantly larger loan, but successfully investing those additional funds can more than compensate for these increased payments.
Additional Tax Considerations to a Cash-out Refinance
While a cash-out refinance helps you avoid capital gains taxes, investors should still consider the following tax-related consequences of this strategy.
Tax Deductibility of Cash-out Refinance Mortgage Interest
According to the IRS: "When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds not related to rental use generally can’t be deducted as a rental expense." In other words, you would not be able to deduct the interest on the $900,000 of the above loan in excess of the original loan amount. Rather, when you complete a cash-out refinance, you need to allocate mortgage interest to the original loan amount (tax deductible) and the increased loan balance (not tax deductible).
However, if you use the cash to make capital improvements on the property securing the loan, you can continue deducting 100% of your mortgage interest. If you opted to use the above $900,000 to expand the office building, you could deduct all of the future mortgage interest while increasing the rent potential (and value) of the property.
Tax Deferral – not Avoidance
Additionally, investors need to understand that a cash-out refinance simply defers capital gains taxes. These refinances don’t let you avoid taxes. When you ultimately sell the property, you will still need to recognize the gains and pay the associated taxes (unless opting for another tax-deferral strategy like a 1031 exchange).
And, the increased loan balance of a cash-out refinance does not increase your taxable basis. That is, even with a new $1,400,000 loan on the above property, you still would have a taxable basis of $1,250,000 (assuming you haven’t made any subsequent capital improvements). In other words, your eventual capital gains will be calculated by subtracting this taxable basis from sales price, even though your outstanding mortgage may be larger than your basis.
While investing in real estate can offer significant tax advantages, the potential exists for major tax bills, as well – especially when selling a property. But, as the above article illustrates, tax planning strategies exist to defer these taxes.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated tax implications.