Cash-Out Refi vs Sell: Pull $200K or Pay 23.8% Tax

Marcus, a single filer in Austin, owns a fourplex he bought in 2014 for $300,000. It is now worth $640,000, he has $200,000 left on the mortgage, and he has claimed $120,000 of depreciation over the years. He needs $200,000 in cash — for a down payment on a larger building. His broker says sell. His CPA says refinance. They are both right about the mechanics and only one is right about the tax.

If Marcus sells, his gain is roughly $400,000 (sale price minus adjusted basis, which is original cost minus the $120,000 of depreciation). The IRS taxes that in two layers: up to 25% on the $120,000 of recaptured depreciation and up to 23.8% on the rest. As a high earner he is in the 15–20% long-term capital gains band plus the 3.8% net investment income tax. The federal bill lands near $96,640 — and Texas takes nothing (no state income tax), so a CA resident would owe even more.

If Marcus refinances, he pulls the same $200,000 and pays $0 in tax. Loan proceeds are debt, not income. He keeps the property, keeps the depreciation, keeps the deferred gain — and keeps a new mortgage payment. That payment is the only real cost, and it is far smaller than the tax he just avoided.

Why a cash-out refinance is tax-free

There is no IRC section that “exempts” refinance proceeds, because there is nothing to exempt. Borrowed money is not income. When the bank wires Marcus $200,000, he has simultaneously taken on a $200,000 obligation to repay it. His net worth did not change, so there is no taxable event — nothing flows to Schedule E, nothing flows to Form 4797.

This is the entire reason the wealthy hold appreciated assets and borrow against them rather than selling. A sale is a realization event: it crystallizes the built-in gain and triggers tax. A loan is not. You convert illiquid equity into spendable cash without ever realizing the gain.

The trade-off is honest: you have not made the tax disappear, you have deferred it. The recapture and capital gains liability stay attached to the property. They wait. They come due only when you sell without a 1031 exchange — or they vanish entirely at death (more on that below).

The sale: what the IRS actually takes

Selling an appreciated rental is one of the most heavily taxed events in the individual code, because it stacks three separate levies. Using Marcus’s numbers — $640,000 sale, $300,000 original cost, $120,000 depreciation claimed (so $180,000 adjusted basis) and a $460,000 gain before selling costs — here is the stack. (We use a clean $400,000 taxable gain after selling costs and exemptions for the illustration.)

Three things drive that $96,640. First, depreciation recapture is not optional — the IRS taxes the depreciation you claimed (or were allowed to claim) at up to 25% under the unrecaptured §1250 rules, even if it pushed your rental into paper losses for years. Second, the long-term capital gains rate is 20% for a high earner (taxable income over $533,400 single in 2026), or 15% in the broad middle band ($48,351–$533,400). Third, the 3.8% NIIT lands on top once modified AGI clears $200,000 single / $250,000 MFJ, and a $400,000 gain blows past that on its own.

That combined 23.8% top rate on the gain portion — 20% LTCG plus 3.8% NIIT — is the headline number. Add the recapture layer and the effective rate on Marcus’s total gain is about 24%.

The refinance: $200,000, zero tax, one payment

Against that, the refinance is almost boring. Marcus replaces his $200,000 mortgage with a $400,000 mortgage, walks away with $200,000 cash, and reports nothing. His only new cost is debt service on the additional $200,000.

• Cash received: $200,000, tax-free.
• New debt: $200,000 additional principal at, say, 7% investor rate.
• Annual interest cost: roughly $14,000 in year one.
• Deductibility: interest on debt secured by a rental and used in the rental activity is deductible against rental income on Schedule E, so the after-tax interest cost is lower than the sticker rate.
• Deferred liability: the $96,640 of recapture and gains tax stays parked on the property, untouched.

The property keeps producing rent to service the new loan, keeps appreciating, and keeps throwing off depreciation deductions. Marcus got his $200,000 down payment and still owns the appreciating asset.

The break-even: how long can you carry the interest?

This is the real decision, and it is just division. You are trading a one-time avoided tax bill against a recurring interest cost. The break-even is:

1. Avoided tax: $96,640 (the sale bill you did not pay).
2. Extra annual interest: $14,000 (7% on the $200,000 of new debt).
3. Break-even, pre-tax: $96,640 ÷ $14,000 = 6.9 years.
4. Break-even, after deducting the interest at a 24% rate: effective interest cost drops to about $10,640/yr, pushing the break-even to roughly 9.1 years.

Read that the right way: as long as Marcus holds the property for fewer than about 7–9 more years, the refinance is strictly cheaper than selling — and that ignores the fact that he keeps the appreciating asset the entire time. If he plans to hold the fourplex indefinitely (or until death), the refinance wins by the full $96,640 because the sale tax may never be paid at all.

*Sale net of $96,640 federal tax and $200,000 mortgage payoff, on a $640,000 sale price before selling costs. The sale gives the most total cash but only by liquidating the asset and triggering the full bill. The refinance gives you exactly the $200,000 you needed with nothing to the IRS.

What most people get wrong: “refinancing avoids the tax”

It does not. The single most common misconception is that pulling equity tax-free means the gain is gone. It is not gone — it is deferred, and it is still attached to the property dollar-for-dollar. If Marcus refinances today and sells in three years, he owes the recapture and capital gains then, on the original gain plus any further appreciation. Refinancing buys time and liquidity; it does not erase the liability.

The second misconception is that refinancing resets basis. It does not. Your adjusted basis, your depreciation schedule, and your deferred gain are identical the day after the refinance as the day before. Nothing about the loan touches the basis math.

The third — and most expensive — mistake is mixing a refinance into a 1031 exchange. Pulling cash out right before or during a like-kind exchange can be treated as taxable boot, defeating the deferral on that slice. If you intend to both exchange and pull cash, close the 1031 first, let the dust settle, then refinance the replacement property as a clean, separate transaction.

The endgame that makes deferral permanent: step-up at death

Here is why “refinance, never sell” is a legitimate strategy and not just procrastination. Under IRC §1014, when Marcus dies, the property’s basis steps up to its fair-market value on the date of death. His heirs inherit it at the new, higher basis — and the entire built-in gain, including all $120,000 of depreciation recapture, simply disappears. It is never taxed.

In community-property states (CA, AZ, ID, LA, NV, NM, TX, WA, WI) a surviving spouse gets a full step-up on both halves of jointly held property; in other states the step-up is generally to the decedent’s half. Either way, the deferred $96,640 can be permanently extinguished. With the 2026 federal estate exemption at $13.99M per individual ($27.98M for a married couple with portability), the vast majority of investors face zero estate tax on the way out, so the step-up is pure savings.

This is the “buy, borrow, die” logic in one rental property. You buy the asset, you borrow against it tax-free whenever you need liquidity, and the gain is wiped clean at death. Selling voluntarily hands the IRS money that a refinance could have deferred — possibly forever.

When selling is still the right call

Refinancing is not always the answer. Sell instead when:

• You genuinely want out of the asset. If you are done being a landlord, no amount of tax deferral justifies keeping a property you do not want. The refinance only makes sense if you keep holding.
• Your taxable income is low enough for the 0% or 15% bracket. A retiree with little other income can sometimes realize gains in the 0% LTCG band (up to $48,350 single / $96,700 MFJ in 2026) or the 15% band — making the sale tax modest and the deferral less valuable.
• You can do a 1031 exchange into a better property. This defers the same tax while upgrading the asset, with no new debt service. If a stronger property exists, the exchange beats both selling-and-paying and refinancing-and-holding.
• The property no longer cash-flows. If rent cannot comfortably cover a larger mortgage payment after the refinance, you are layering debt onto a weak asset. Run the post-refi DSCR before borrowing.

The decision lever

Ask one question: do you want the cash and the property, or do you want out? If you want both the liquidity and the asset, the cash-out refinance is almost always the answer — $200,000 in your hands at $0 tax beats a sale that strips $96,640 off the top. If you actually want out of the property, then compare a straight sale against a 1031 exchange, and refinancing is irrelevant.

Run your own version of Marcus’s break-even before you commit: avoided sale tax divided by your incremental annual interest, then adjusted for the interest deduction. If that number is larger than the years you plan to keep holding, refinance. If you plan to hold to death, the math is not even close — the §1014 step-up makes the deferred tax a bill your heirs will likely never see.