The Timing and Tax Matters of Refinancing Long-Term Debt

In recent years the Federal Reserve Board has managed to keep interest rates at historical lows. With inflation on the rise, however, it recently raised those rates for the first time in nearly a decade. And that’s a sign that long-term interest rates could be ready to jump.

So now is the time to consider refinancing long-term debt, including commercial property mortgages. And before you sign the dotted line, keep in mind the possible income tax consequences.

The Benefits

The Fed maintains a targeted rate for its Federal Funds Rate (FFR) to help maintain economic stability. In March of 2020, it lowered that range to 0-0.25% in the face of the COVID-19 pandemic and its resulting impact on the economy. For the most part, this has led to favorable lending rates in an effort to spur recovery.

However, many forecasters expect the Fed to bump the FFR into the upper range of 1.5% to keep inflation in check. With higher long-term interest rates likely in the near future, it could be a wise move to refinance commercial property now. Why?

Added cash flow. Refinancing now would lock in lower interest rates with up to 30 years amortization. The resulting lower payments could free up your cash flow for other business needs.

Maximized cash-out refinancing. If your real estate has increased in value, you may be able to borrow more money than you currently owe on your property by taking advantage of the additional equity (market value minus any liens). This is called cash-out refinancing, and it allows you to benefit from the assets’ worth without having to sell them.

Restructure debt to your advantage. Consolidating your commercial mortgage with other forms of debt can significantly reduce your overall payments. Combine that with a lower interest rate and you could see huge savings (and again, added cash flow).

The Tax Considerations

Sure, refinancing has its financial advantages. But if you’re not careful, those benefits can be blunted by unexpected tax consequences. (That said, you can also find some advantages!) So it’s important to know how taxes work in your situation.

For example, you’re generally allowed to deduct mortgage interest paid on your commercial mortgage debt. This deduction is a common tax benefit for commercial real estate owners. But if you refinance at a lower rate, you’re paying less in interest — so the dollar amount you deduct goes down with it. Additionally, if your refinance results in a shorter term on your mortgage, you’ll have fewer years in which that interest is paid (and therefore deducted).

You also need to be aware of tax rules regarding cash-out refinancing. If you’re spending the resulting funds for reasons other than improvements to the property and other business purposes, you may not be able to deduct the full amount of mortgage interest for tax purposes. When a taxpayer borrows funds, a common misconception is that the deductibility of interest expense is determined by how the loan is collateralized. That is not the case. In fact, this is determined based on how the loan proceeds are used (otherwise referred to as interest tracing).

Getting Started

There are several options when it comes to refinancing long-term debt. For example, some offers can extend payment terms or provide less exposure of your assets from a lender recourse perspective. There will also be different products with structures tailored to specific assets or asset types. The best options aren’t cut and dry; they depend on your particular situation and your enterprise’s financial goals.

This is why it’s best to consult a knowledgeable lender and your real estate CPA for help if you’re even considering a refinance. Their insight on your business and financials —and your CPA’s knowledge of the tax laws governing them — are key to maximizing the results of your efforts.

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