Demystifying Refinance Implications

We recently refinanced one of our properties, resulting in a distribution of 50% of the original equity back to investors. While this is a great accomplishment, some investors had questions about the economic and tax implications, which we aim to clarify in this article.

The concerns can be divided into two categories: partnership considerations and tax implications. First, let's address the partnership considerations. When investing in a real estate partnership, an investor's distributions are determined by the waterfall. Although there are various ways to structure a partnership, we will focus on Lone Star Capital's deal structure. Our typical waterfall includes an 8% cumulative and compounding preferred return, followed by a 100% return of capital. Subsequently,distributions are split 70% to investors and 30% to Lone Star Capital up to a15% IRR. Once a 15% IRR is delivered to investors, any remaining distributions are split 50/50.

According to the waterfall structure above, cash-out refinance proceeds would be distributed back to investors, first to pay or catch up the preferred return (if necessary), then to pay down the investor's capital account. This is where some confusion arises. It's important to note that a reduction in an investor's capital account for the purposes of the waterfall does NOT dilute the investor's interest in the investment (for tax purposes or otherwise). If the investor owned 5% of the investment before therefinance, they would continue to own 5% of the investment after. However, perthe waterfall, the investor will have a reduced capital account, and the preferred return calculation will be based on the new capital account moving forward. The investor would continue to receive 5% of any distributions just as they had previously.

Additionally, the sponsor, in this case, does not receive any promote or performance compensation from a refinance unless the refinance proceeds exceed both the catch-up of the preferred return and the 100% return of capital. This is highly unlikely and essentially inapplicable in most scenarios.

As a result of a cash-out refinance, additional debt is taken on by the investment, which may lead to a reduction in the total free cash flow on an absolute dollar basis (unless the new interest rate is significantly lower than the previous one). Despite a possible decrease in free cash flow,the cash-on-cash return may potentially increase, given that the denominator(remaining cash invested in the deal) is reduced through the cash-out proceeds.Even if the cash-on-cash percentage remains constant after refinancing, the cash-out refinance still represents a significant advantage, as the distributed proceeds can be utilized to invest in new opportunities. These new ventures are likely to yield a higher total return than the cash-on-cash return the equity was generating before the refinance, as the refinanced deal is most likely stabilized and has limited upside remaining to be captured.

Regarding tax implications, a cash-out refinance is not considered a taxable event since the cash distribution arises from a loan rather than a capital gain. The investor's capital account on their K-1 will be reduced by the distribution amount and could even become negative (as in our recent case), but this is entirely normal and does not result in any tax consequences. When the property is sold, capital gains taxes and depreciation recapture will be due. The property's first-year bonus depreciation remains unaffected, and its capacity to produce future depreciation remains unchanged.