Mike had a plan.
He owned a $5 million commercial property with minimal debt—about $350,000. He was ready to sell and move into something passive. So far, so good.
His idea: refinance the property for $1.5 million, pull out roughly $1.15 million in cash, and invest the remaining equity into Delaware Statutory Trusts at 30% leverage.
Liquidity plus tax deferral. Best of both worlds.
When we got on a call to talk through his plan, I asked Mike a simple question:
“What do you need the $1.15 million for?”
His answer: “We just thought it would be a good idea to take some money out. What do you think?”
That told me everything I needed to know.
Running the Numbers
There was no specific goal behind the cash-out. No college tuition. No business opportunity. No liquidity crisis. Just an assumption that pulling money out was somehow advantageous.
So we ran two scenarios together.
Scenario A: Cash-Out Refinance + Partial Exchange
Mike refinances before selling, takes $1.15 million in cash, and invests approximately $3.5 million into DSTs.
At a 5% cash-on-cash return, he’d generate about $175,000 per year in income. Without significant depreciation shelter, his after-tax income would be roughly $120,000 annually.
Scenario B: Full 1031 Exchange
Mike sells without refinancing and invests the full $4.65 million into DSTs.
At the same 5% return, he’d generate over $200,000 per year in income. With proper exchange structuring and depreciation optimization, nearly all of that income can be sheltered.
The difference:
- Over $100,000 more income per year
- Over $500,000 additional income over five years
- $350,000+ in potential tax savings
Mike’s response was immediate: “The exchange makes a lot more sense than the cash-out refi.”
Why This Keeps Happening
Mike isn’t unusual. We see variations of this constantly.
The problem isn’t that investors make bad decisions, they make uninformed decisions. It’s that cash-out refinancing sounds smart. Liquidity feels like optionality. And no one wants to leave money locked up if they don’t have to.
But the math often tells a different story.
Every dollar you pull out of an exchange is a dollar that stops working for you. At 5% returns, $1 million in cash-out costs $50,000 per year in lost income—before considering the tax implications.
And there’s another risk: a cash-out refinance shortly before a sale can sometimes be treated as taxable boot by the IRS, especially if it looks like you’re extracting equity to avoid exchange requirements. That’s a problem that’s easy to avoid with planning—and expensive to fix after the fact.
Questions to Ask Before You Refinance
If you’re thinking about pulling cash out before a 1031 exchange, here’s what to consider:
1. Do I actually need the money?
If the answer is “yes, for X,” great—let’s figure out the smartest way to do it. If the answer is “we just thought it would be a good idea,” it’s worth running the numbers first.
2. What’s the real cost?
There’s more to it than just income.
That extra $1 million Mike kept in the exchange didn’t just generate more cash flow—it also created about $225,000 in additional depreciation over five years. That’s another $75,000 in tax savings.
Add it up: keeping that money invested instead of pulling it out put roughly $65,000 per year in Mike’s pocket—after taxes.
Depending on your tax situation, that’s the equivalent of earning 10% on a taxable investment. Try finding that in a savings account.
3. Is there a tax risk?
Depending on timing and structure, a pre-sale refinance can trigger unexpected taxes. This is worth checking before you commit.
4. Have I seen the comparison?
Most investors have never seen a side-by-side breakdown of their options. It takes about 40 minutes to run the scenarios—and the difference is often six figures.
The 40-Minute Conversation
It took forty minutes to walk through the analysis with Mike. That conversation was worth over $500,000 in additional income and $350,000 in tax savings over five years.
He didn’t need to become a 1031 expert. He just needed to ask the right question before the closing date.
Thinking About a Sale?
If you’re approaching a sale and considering your options, we’re happy to run scenarios with you. No cost, no obligation—just clarity before decisions get locked in.
The difference between “good enough” and “optimal” is often measured in hundreds of thousands of dollars. Worth knowing before you commit.
Frequently Asked Questions
1. What is pre-closing 1031 exchange planning?
Pre-closing planning means analyzing your situation before the property sale closes to identify the best approach. This includes evaluating refinancing decisions, , replacement property strategies, and depreciation positioning. The goal is to shape the outcome rather than just document what happened.
2. Why would I consider a cash-out refinance before a 1031 exchange?
Some investors refinance before selling to access liquidity while still deferring taxes on the remaining proceeds. This can make sense when there’s a specific need—funding another investment, or addressing debt. But when there’s no clear purpose, you may be giving up significant income and tax benefits without realizing it.
3. Can a cash-out refinance before a sale create tax problems?
Yes. Depending on timing and structure, a cash-out refinance shortly before a sale can potentially be treated as taxable boot by the IRS—especially if it looks like you’re extracting equity to avoid exchange requirements. Proper planning may mitigate these risks, but the analysis needs to happen before closing.
4. How much does pre-closing planning cost?
We offer complimentary consultations to walk through your situation and run scenarios. There’s no cost to find out what your options look like.
5. When should I reach out?
The earlier the better—ideally before any refinancing decisions and well before the property goes into escrow. Once the closing statement is finalized, many optimization opportunities are lost. If you’re even considering a sale in the next 6-12 months, it’s worth having a conversation.
