BY: MARY LOU SCHWAB CPA, CES
Many issues with lending can create unplanned legal or tax consequences and at times may prohibit a mortgage from being funded at closing.
Check out the following lending issues prior to your 1031 exchange transaction:
1. Clean up the old property title by transferring it to your individual name. Mortgage portfolio lenders will not lend to living trusts, revocable trusts, partnerships or limited liability companies. Remember that the IRS considers a single owner trust, a single member limited liability company or a husband and wife owned partnership as a disregarded entity. This means that you can transfer ownership back and forth with no federal tax effects and still obtain the mortgage lending. Be sure to check that you don't trigger a "due on sale clause" in your mortgage note when transferring such ownership back and forth.
2. Mortgage lenders understand the purpose of a 1031 exchange – investment property purchase. Don't try to obtain 2nd home mortgage financing for a 1031 replacement property. The underwriters will not fund a loan if you misrepresent the use of the property.
3. If proceeds from a mortgage loan cause an exchanger to receive cash at closing of the replacement property, the exchanger will incur a tax liability. Instead request to have your earnest money refunded or apply the excess as a principle reduction payment on the settlement statement to avoid capital gains tax.
4. When participating in a reverse exchange do not utilize a residential mortgage lender who sells their loans to other investors. Only commercial banks will lend to a Limited Liability Company (LLC) which acts as the parking entity for a reverse exchange. The commercial bank will want the exchanger to guarantee the loan or will tie up additional collateral the Exchanger may have. Some commercial banks are resistant to lending to the LLC entity which parks the replacement property for the exchanger. Other commercial banks look to the credit strength of the exchanger and will fund 90 to 100% of the purchase price. Generally the lending is bridge type financing and can be interest only. Often reverse lending loans take more time to fund as there are additional requirements such as environmental reports, surveys, commercial appraisals, liability insurance and the loan committee approval process. Understanding the commercial bank requirements for a reverse parking loan will allow an exchanger to coordinate closing dates, allowing time for loan processing.
5. Many exchangers purchase replacement property in the form of Tenant- In-Common (TIC) percentage interests in large commercial or apartment complexes.
6. Realize that mortgage lenders often cannot fund a loan on the day of closing. Occasionally, exchangers will coordinate simultaneous exchange closings at the same title company to save on exchange fees. Both the old property sale and the new property purchase must occur on the same day. If the buyer's mortgage lender doesn't fund their loan when the old property is sold, the sale is closed in escrow. The exchanger should not continue with the closing paperwork for the purchase of the new property without a qualified intermediary involved. The 1031 exchange will not be allowed by the IRS if the old property closes in escrow without the use of a qualified intermediary.
7. Be careful when you refinance to take money out of your old investment property. An exchanger should not obtain cash out refinance on their old property immediately before their 1031 exchange transaction. The IRS will not allow the 1031 exchange if an exchanger can't prove they used the cash proceeds to improve the old property. Remember that an exchanger can immediately refinance their new replacement property after the 1031 exchange transaction is complete and take cash out without any tax ramifications.
For the savvy real estate investor, a 1031 exchange can defer taxes and generate more cash flow and appreciation potential. Part of the equation for higher cash flow is to structure the best possible mortgage loan. By planning ahead, exchangers will obtain their investment goals with the flexible mortgage products available in the market place. Plan your next 1031 exchange with lending issues in mind! Please note that all material provided in this newsletter is for informational purposes only and the author is not providing legal, tax accounting or other professional services. The accuracy of the information provided as it pertains to your situation is not guaranteed.
Please seek professional consultation if legal, tax accounting or other expert assistance is required.