When planning a 1031 exchange, decisions can feel straightforward—until you look at the long-term implications. Recently, I had a conversation with an investor that perfectly illustrated this point. He owned a $5 million property with $350,000 in debt and was considering a bold move: refinancing the property for $1.5 million, taking $1,150,000 in cash, and reinvesting the rest into a Delaware Statutory Trust (DST).
On paper, it seemed like a win-win: liquidity from the cash-out and tax advantages from the exchange. But, as is often the case, the numbers told a different story.
Asking the Right Questions
When he shared his plan, I asked him a simple but pivotal question:
“Why do you want to take $1,150,000 out of the exchange?”
His response was refreshingly honest:
“We just thought it would be a good idea to take some money out. What do you think?”
This was a classic case of exploring an option without fully considering the long-term trade-offs. While cash-out refinancing can seem appealing, the decision isn’t as straightforward as it appears.
Crunching the Numbers: Two Scenarios
To help him understand the implications, we ran two scenarios side by side.
Scenario 1: Cash-Out Refinancing
- Refinance the property for $1.5 million, taking $1,150,000 in cash.
- Reinvest $3.5 million into a DST.
- Annual Income Generated: $175,000
- After-Tax Income: $120,000
Scenario 2: Full 1031 Exchange
- Reinvest the entire $5 million into a DST.
- Annual Income Generated: $250,000
- After-Tax Income: $250,000
The Financial Trade-Offs
The difference between the two scenarios was striking:
- $130,000 more income per year by opting for the full exchange.
- $650,000 additional income over five years.
- $300,000 in potential tax savings.
The cost of taking $1,150,000 out of the exchange? A significant reduction in both annual income and overall tax efficiency.
Making the Decision
Armed with this perspective, the investor quickly realized the full 1031 exchange made far more financial sense. His takeaway?
“The exchange makes a lot more sense than the cash-out refi.”
This wasn’t just a numbers game—it was a shift in mindset. The initial appeal of quick cash gave way to the clarity of long-term financial growth and stability. And that’s a decision-making process that applies universally to anyone considering a similar move.
What This Means for You
Whether you’re an investor managing your portfolio, a financial advisor guiding a client, or simply exploring options, this story underscores an essential truth: decisions about 1031 exchanges should be informed by data, not assumptions.
Refinancing and taking cash out can be the right move in specific situations, such as addressing immediate financial needs or seizing high-return opportunities. However, for those without a pressing need, the long-term benefits of keeping funds fully invested in a 1031 exchange often outweigh the short-term appeal of liquidity.
Maximizing the Value of a 1031 Exchange
If you or someone you know is considering taking cash out of a 1031 exchange, take the time to carefully weigh the benefits and drawbacks. A data-driven approach can illuminate hidden costs, identify opportunities, and help ensure the decision aligns with overall financial goals.
Key Questions to Consider Before Refinancing in a 1031 Exchange:
- What is the purpose of taking cash out?
If it’s for a clear, strategic goal, refinancing may make sense. But if it’s “just because,” it might be worth reconsidering. - What are the long-term income implications?
How will the decision impact annual cash flow and overall tax efficiency? - Can the investment grow without taking cash out?
Keeping proceeds fully invested can often provide compounding benefits over time. - Are there tax consequences to consider?
Cash taken out of an exchange, known as “boot,” is taxable as capital gain and can erode the financial advantages of the exchange. - What are the alternatives?
Exploring other ways to achieve liquidity, such as partial exchanges or strategic refinancing, might offer a better balance.
Conclusion: Decisions Built on Insight
This investor’s story is a reminder that the best decisions are informed decisions. While cash-out refinancing can have its place, it’s critical to consider how it aligns with long-term goals.
At Exchange Planning Corporation, we specialize in helping investors, advisors, and professionals navigate these nuanced decisions. Whether it’s evaluating scenarios, projecting income, or structuring an optimal exchange, we’re here to provide the insights that lead to smarter choices.
Ready to make your next move?
Contact us today for a consultation and learn how we can help you maximize the value of your 1031 exchange. Every decision counts—let’s ensure yours is the right one.
