1031 Exchange Guide for Lenders and Mortgage Brokers

Vesting must match the seller: a new entity is a new taxpayer unless it is disregarded

Section 1031 defers gain only for the taxpayer that exchanged, so the borrower that takes title to the replacement must be the same taxpayer that sold. Under Reg. section 301.7701-3, a domestic LLC with a single owner is 'disregarded as an entity separate from its owner' unless it elects otherwise, while one with two or more members is a partnership. Your single-purpose-entity requirement therefore works if the new LLC is wholly owned by the person or entity that sold.

Problems start when the loan committee asks for a co-borrower or a second member. Adding a spouse, partner or investor as a member makes the borrower a partnership, which is a different taxpayer from the individual who sold. A personal guaranty from the same people does not create the problem; a change of ownership does. The same-taxpayer rule covers the common variations.

Check the sale side too. If the relinquished property was sold by a partnership, the partnership must also be your borrower, and its partners cannot each borrow and buy separately unless the property was moved into their individual names well before the sale. A title report, the seller's closing statement and the exchange agreement will show you who the exchanger is; ask for all three with the loan application rather than at the end of underwriting.

Size the loan to the debt paid off at the sale, or the borrower pays tax on the shortfall

Under Reg. section 1.1031(b)-1(c), the mortgage paid off when the old property sells is treated as money the borrower received. Debt the borrower takes on with the replacement offsets it, and so does cash the borrower adds; Reg. section 1.1031(d)-2 works through examples where liabilities on both sides net against each other.

Hypothetical: the borrower sold for $1,500,000 and paid off a $600,000 mortgage, so $900,000 is with the intermediary. To defer fully, the borrower buys at least $1,500,000 of property, uses all $900,000, and covers at least $600,000 with your loan or added cash. A $500,000 loan leaves $100,000 of debt relief that is taxable unless the borrower brings $100,000 from savings. Replace the mortgage or add cash explains the trade-off; the figures are hypothetical, so the borrower should run their own numbers with a CPA.

Over-replacing debt creates no tax problem. A larger loan than needed is fine for the exchange, as long as loan proceeds are not paid out to the borrower at closing.

Exchange funds arrive at the closing table from the intermediary, and you cannot take them as collateral beforehand

The exchange agreement must limit the borrower's rights to 'receive, pledge, borrow, or otherwise obtain the benefits of' the money held by the intermediary until the exchange period ends, under Reg. section 1.1031(k)-1(g)(6). Do not ask for a pledge of the exchange account or a transfer of the funds to the borrower's own account to verify assets. Ask the intermediary for written confirmation of the balance and for its wire instructions to the closing agent.

Loan fees and points paid from exchange funds can create a small amount of boot; loan fees and points paid from exchange funds explains the treatment. The 180-day deadline does not move for an appraisal or an underwriting delay, so issue commitments early and keep the closing date inside the period; when a lender delay threatens the deadline lists the fallbacks.

In a reverse exchange you lend to the accommodation titleholder, and the borrower guarantees

When the borrower buys before selling, an exchange accommodation titleholder takes title under Rev. Proc. 2000-37. The parking agreement must be signed within five business days after title passes, the relinquished property must be identified within 45 days, and the combined period both properties are parked may not exceed 180 days. The procedure expressly permits the taxpayer to guarantee the titleholder's obligations, 'including secured or unsecured debt incurred to acquire the property,' and to lend or advance funds to it.

Rev. Proc. 2004-51 adds that the safe harbor does not apply to replacement property the borrower owned within the 180 days before the titleholder took title. Expect the titleholder to be a single-purpose entity with a nonrecourse posture and the borrower's guaranty as the credit; at the end of the exchange title moves to the borrower, and your loan is typically assumed or refinanced. The reverse 1031 exchange guide covers the full sequence.

DST interests bring their own nonrecourse loan, which changes how much new debt your borrower needs

In Rev. Rul. 2004-86 the trust takes the property subject to a nonrecourse loan, and its trustee 'may not renegotiate the terms of the debt.' Because each owner is treated as holding an undivided fractional interest in the real estate, the owner's share of that loan counts as replacement debt. A borrower who splits proceeds between a property you finance and DST interests can use the trust's debt to cover part of the payoff.

Highly leveraged trusts are designed for this. The client's cash out DST describes zero-cash-flow trusts whose nonrecourse leverage can satisfy debt requirements with a small part of the proceeds.