Introduction:
Did you know that you can avoid capital gains taxes through cash-out refinance? Let me show you how in this article.
Commercial Real Estate Financing
A property that is utilized primarily to profit for a business, as opposed to a residence, is classified as commercial real estate (CRE). Retail malls, shopping centers, office complexes, and hotels are all examples of this development. Commercial real estate loans—mortgages backed by liens on commercial property—are commonly used to fund these properties’ purchase, development, and construction.
Banks and private lenders make commercial real estate loans like home mortgages. Commercial real estate financing sources include the Small Business Administration’s 504 Loan program, insurance firms, pension funds, and private investors.
Commercial real estate loans are frequently made to corporations rather than individuals, as with residential mortgages (e.g., corporations, developers, limited partnerships, funds, and trusts). These organizations are frequently set up solely to amass real estate holdings.
Lenders may request personal guarantees from the proprietors or owners of a company if the latter lacks a financial track record or credit rating. This gives the lender a person (or group of people) from whom they can recover if a loan is defaulted upon. Non-recourse loans are those for which the lender has no recourse against the borrower or anything else besides the loaned property in the case of default. The lender in these situations does not require this form of guarantee.
Rates and Fees for Commercial Real Estate Loans
Commercial loans typically have higher interest rates than residential loans. Commercial real estate loans typically include expenses such as appraisal, legal, loan application, loan origination, and survey fees, which contribute to the overall cost of the loan.
Before a loan can be accepted (or rejected), some expenses must be paid fully upfront, while others must be reapplied each year. For example, a loan may include a 1% one-time origination cost due at closing and a 0.25 percent yearly fee until the loan is paid in full.
Prepayment
A commercial real estate loan may have prepayment limitations to protect the lender’s expected return on the loan. Investors that pay off their loans early will almost certainly be hit with prepayment penalties. Exit penalties for paying off a loan early fall into one of four general categories:
Penalty for paying in advance. The most basic prepayment penalty is multiplying the current outstanding sum by a chosen prepayment penalty.
Guarantee of interest. Even if the loan is paid off early, the lender is entitled to a certain amount of interest. For example, the interest rate on loan may be guaranteed at 10% for the first 60 months and then be subject to a 5% exit fee after that.
Lockout. For example, a five-year lockout means the borrower can’t pay off the debt before that time has expired.
Defeasance. As an alternative to a down payment, new collateral (often U.S. Treasury securities) is exchanged for the original loan collateral by the borrower instead of cash. This technique of paying off a debt can save money but also come with hefty penalties.
In commercial real estate loans, terms for prepayment and other loan provisions are specified in the loan agreements and can be discussed throughout the loan negotiation process.
Real estate investing can give significant tax benefits.
Real estate investing can give significant tax benefits. However, selling an investment property can result in a hefty capital gains tax payment. If you wish to access the equity in your home, these taxes may deter you from selling. Cash-out refinances, fortunately, provide an alternative, allowing investors to A) convert available equity into cash and B) avoid capital gains taxes. As a result, we’ll use this post to illustrate how to avoid capital gains taxes with a cash-out refinance.
We’ll go through the following subjects in particular:
- Overview of Capital Gains Tax
- Avoiding Capital Gains Taxes with a Cash-Out Refinance
- Final Thoughts on Cash-Out Refinance Tax Considerations
Overview of Capital Gains Tax
When you sell a capital asset (for example, an investment property) for more than you paid, you realize a capital gain. The IRS, as with most gains, wants its part. As a result, investors must normally pay capital gains tax on their gains. The IRS taxes capital gains at 0%, 15%, or 20%, depending on your income bracket (and presuming you’ve owned the property for more than a year).
When you buy an investment property, the purchase price is usually your taxable basis or the amount used to calculate future capital gains. If you spend money renovating the property before leasing it, the cost of those improvements will be added to your taxable basis.
For example, suppose you pay $1,000,000 for a vacant office building. You spend another $250,000 upgrading the building before leasing it. As a result, when you lease the property after rehabilitation, your taxable basis will be $1,250,000 ($1,000,000 acquisition cost + $250,000 in renovations).
You decide to sell the building after five years of leasing it. A $2,000,000 sales price, ignoring transaction costs, would result in $750,000 in capital gains ($2,000,000 sales price minus $1,250,000 taxable basis).
Note: The preceding example disregards the tax consequences of depreciation recapture.
Avoiding Capital Gains Taxes with a Cash-Out Refinance
Assume you wish to avoid paying the $150,000 tax bill. However, you would also like to turn some of your increasing equity into cash. Here comes the cash-out refinance. A cash-out refinance your old mortgage with a new, larger loan, and you keep the difference as cash.
This cash-out refinance not only gives you access to cash but it also provides a significant tax benefit. In particular, the IRS does not consider the proceeds of a cash-out refinance to be income. Instead of selling your home and incurring capital gains tax, you take out a larger loan, pay down the previous mortgage, and cash out the difference.
This approach allows you to A) turn the equity in an investment property into cash while B) avoiding capital gains taxes.
An Example of a Cash-Out Refinance
Continuing with the previous scenario, suppose you have a $500,000 mortgage on your property after five years. A recent appraisal also affirmed the property’s $2,000,000 valuation. Assume your lender offers a cash-out refinance package with a loan-to-value of up to 70%. (a common standard with commercial refinances). This means you’ll be able to get a new loan for $1,400,000 ($2,000,000 worth multiplied by 70% LTV).
To keep things simple, a portion of the new mortgage must be used to pay down the old debt. This leaves you with $900,000 ($1,400,000 new loan less $500,000 previous loan payoff). In other words, you just got $900,000 in cash and didn’t have to pay any taxes. Of course, you’ll have to make monthly payments on a much larger loan, but investing that extra cash effectively can make up for the higher payments.
Tax Considerations for a Cash-Out Refinance
While a cash-out refinance allows you to avoid capital gains taxes, investors should examine the following tax implications of this strategy.
Mortgage Interest from a Cash-Out Refinance Is Tax Deductible
“When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds that is not attributable to rental usage normally cannot be deducted as a rental expenditure,” according to the IRS. In other words, you cannot deduct the interest on the $900,000 loan above the original loan amount. Instead, when you do a cash-out refinance, you must assign mortgage interest to the original loan amount (tax-deductible) and the higher loan sum (not tax deductible).
However, if you use the funds to make capital improvements to the property that secured the loan, you can continue to deduct 100% of your mortgage interest. If you utilized the above $900,000 to extend the office building, you could deduct all future mortgage interest while boosting the property’s rent potential (and value).
Tax Deferral rather than Avoidance
Furthermore, investors must note that a cash-out refinance postpones capital gains taxes. This refinance does not allow you to avoid paying taxes. When you sell the property, you must still recognize the gains and pay the corresponding taxes (unless opting for another tax-deferral strategy like a 1031 exchange).
Furthermore, the higher loan balance of a cash-out refinance does not affect your taxable base. Even if you took out a new $1,400,000 loan on the same property, you would still have a taxable basis of $1,250,000 (assuming no additional capital improvements). In other words, even if your outstanding mortgage is greater than your basis, your future capital gains will be determined by reducing this taxable basis from the sales price.
While investing in real estate can provide considerable tax benefits, there is also the possibility of significant tax obligations, particularly when selling your property. However, as the preceding article demonstrates, tax planning options exist to delay these taxes.
We’d love to discuss other real estate investing opportunities for your specific scenario! Please send us a mail for a meeting to discuss various passive real estate investment alternatives and the tax consequences.
It’s common for a company entity to purchase a property, lease out the space, then collect rent from businesses that operate there. The investment’s primary goal is to serve as a source of revenue.
For commercial real estate loans, lenders glance at the collateral, creditworthiness of the company (or owners/principals), and financial parameters like the loan-to-value ratio and the debt-service coverage ratio when assessing the loan application.
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