Exchanging a Property With an SBA Loan: Payoff, Fees and Replacement Debt

The building qualifies because your business used it; the SBA loan changes the arithmetic, not the eligibility

Section 1031(a)(1) defers gain on real property 'held for productive use in a trade or business or for investment' when it is exchanged for like-kind real property. A building your own company occupied meets the first half of that test even though you never collected rent from an outside tenant. Nothing in the statute or the SBA regulations treats SBA financing as a bar.

What the SBA loan does change is the money flow at closing. The title company pays the lender off from the buyer's funds, and only the net proceeds go to your qualified intermediary. Under Reg. section 1.1031(b)-1(c), a liability you are relieved of is treated as money received, so the payoff is part of what you must replace.

Check who actually holds title before anything else. Many SBA borrowers own the real estate in a separate entity that leases it to the operating company. That landlord entity is the taxpayer that must sell, identify and buy, and the same-taxpayer rule applies to it, not to the business that occupies the space.

An early payoff can carry an SBA fee, and the timing of your sale decides whether it applies

For 7(a) loans, 13 CFR 120.223 imposes a subsidy recoupment fee, usually called the prepayment penalty, when three conditions are all met: the loan has a maturity of 15 years or more, you prepay during one of the first three 12-month periods after first disbursement, and the prepayment exceeds 25% of the highest outstanding balance in that period. The charge is 5% of the prepayments in the first year, 3% in the second and 1% in the third. A sale that pays the loan off in full after the third year triggers no SBA fee under this rule.

504 loans work differently. Under 13 CFR 120.940, the borrower may prepay only by paying the entire principal balance, unpaid interest, unpaid fees and 'any prepayment premium established in the note.' Read the 504 note and the bank's first-lien note separately; the bank portion of a 504 project carries whatever prepayment terms the bank wrote.

Hypothetical: a 7(a) loan with a 25-year term has a $600,000 balance when the building sells in month 20, inside the second 12-month period. The fee is 3% of $600,000, or $18,000, paid from the proceeds at closing. Whether your CPA treats that charge as a selling expense that reduces the amount realized is a question to settle before closing; run your own numbers with your CPA.

The loan payoff is debt relief: replace it with new debt or your own cash, or part of the gain is taxed

Reg. section 1.1031(d)-2, Example 1 shows the mechanics: an owner who transfers a building subject to a $150,000 mortgage is treated as receiving $150,000, and that amount is recognized to the extent of the gain unless it is offset. Under Reg. section 1.1031(b)-1(c), debt you take on with the replacement offsets debt you were relieved of, and cash you add offsets it too.

Hypothetical: the building sells for $2,000,000 with $100,000 of selling costs and a $900,000 SBA and bank payoff, leaving $1,000,000 for the intermediary. To defer all of the gain you buy at least $1,900,000 of replacement property, put in the full $1,000,000, and cover the other $900,000 with new debt or added cash. The Exchange Equation walks through the same balance in more detail; run your own numbers with your CPA.

If the new lender will lend less than the old balance, the gap is taxable mortgage boot unless you fill it with cash. Deleveraging with a 1031 covers what happens when you deliberately take on less debt.

SBA will finance an owner-occupied replacement but not a passive one, which shapes the replacement you can buy

13 CFR 120.110(c) makes ineligible any passive business owned by developers and landlords that do not actively use or occupy the assets acquired with the loan, except Eligible Passive Companies. Under 13 CFR 120.111, an Eligible Passive Company must lease the property to an operating company for that company's business, under a written lease subordinate to SBA's lien, with the rents assigned as collateral.

Occupancy thresholds follow in 13 CFR 120.131: for an existing building the borrower must permanently occupy and use at least 51% and may lease up to 49%; for new construction it must occupy at least 60% and may lease up to 20% permanently. If you are moving the business into a larger building, SBA financing for the replacement remains possible. If you are retiring from the business and buying a rental, a net-leased building or a DST, it is not.

For a passive replacement the debt has to come from a conventional or commercial lender, from your own cash, or from a DST's existing loan. Under Rev. Rul. 2004-86 a DST owner holds an undivided fractional interest in the real estate, and the trust's nonrecourse loan comes with it; whether a DST loan counts as replacement debt explains the allocation.

Sequence the payoff letter, the lender conversations and the identification before the 45-day clock starts

An SBA borrower usually has more parties to coordinate than a landlord with one bank loan. Order the work so nothing is decided under deadline pressure.

• Request payoff statements for every loan on the property, and ask each lender in writing whether a prepayment fee or premium applies on your expected closing date.
• If the buyer wants to assume a 504 loan, start early: 13 CFR 120.937 allows assumption only with SBA's prior written approval, and 120.971 caps the assumption fee at 1% of the balance.
• Confirm which entity holds title and make sure that same entity signs the exchange agreement with the qualified intermediary before closing.
• Get a replacement-loan term sheet before listing; your identification on day 45 must be property you can actually finance by day 180.
• If the business is moving, check the 51% occupancy test against the replacement building's floor plan before you identify it.