Wealth Opportunities in Commercial Real Estate: Management, Financing, and Marketing of Investment Properties

Taxation in the Event of a Refinance

As a general rule, a refinance is a nontaxable event. However, there are exceptions.

One exception that arises frequently is when a mortgage is originated in excess of the property's basis. In our hypothetical scenario, Diamond Jack acquired the medical office building in 2005 for $12,500,000 and sold the property to Steven Stable in 2007 for $14,500,000. Let us assume that instead of selling the center, Jack obtains a new loan of $10,875,000. He refinances the center. Let us also assume that at the time of the refinance, the property's basis is $9,807,692, that is, the $10,200,000 purchase price less two years of depreciation. The result is a mortgage in excess of basis of $1,067,308 ($10,875,000 less $9,807,692). Even if the new mortgage exceeds the property's basis there is no tax incidence if there is no distribution, but if proceeds are distributed, a taxable event occurs.

If the property ownership is held in the name of an entity—for example, a limited liability company (LLC)—one potential way to defer the $1,067,308 tax hit is to characterize the distribution as a loan from the LLC rather than distributed net loan proceeds. Of course, the members must repay the loan. and to the extent the LLC increases distributions during the year, since it has extra cash from the members' loan payments, the extra payments are taxable. The advantage of characterizing the distribution this way is that the tax obligation is spread out over the life of ...