Understanding IRS Rules for 1031 Exchanges: The Impact of Financing and Key Strategies

Before signing a purchase contract for a property as part of your 1031 exchange, it’s vital to ensure that the property type and location meet your lender’s criteria. This is particularly important when considering the debt and equity requirements set by the IRS.

Equity and Debt Requirements

  • Equal or Greater Debt: To avoid taxable “boot” (the excess cash or non-like-kind property received in the exchange), the debt on the replacement property must be at least equal to the debt on the relinquished property. If it’s not, you may need to bring in additional cash or financing.
  • Equal or Greater Equity: The equity invested in the replacement property should match or exceed the equity in the relinquished property. This often requires securing financing, especially if the replacement property is more expensive.

The IRS has strict rules for 1031 exchanges, especially regarding reinvesting proceeds and assuming debt. If these debt and equity requirements aren’t met due to financing issues, you risk losing some or all of the tax deferral benefits. Therefore, it’s crucial to ensure the replacement property is financeable in a way that complies with these rules.

Here’s are six factors to consider when arranging financing for your 1031 exchange:

1. Strategic Planning Before Entering a Contract

  • Lender Requirements: Different lenders have specific criteria for approving financing based on the type of property (e.g., retail, industrial, multifamily) and its location. Before committing to a purchase, confirm that the property you’re interested in meets these requirements to avoid potential financing issues that could jeopardize the exchange.
  • Pre-Approval and Loan Commitment: Before entering into a purchase contract, obtaining pre-approval or a loan commitment from your lender can provide confidence to both the buyer and seller that the financing will go through. This is particularly important in a 1031 exchange, where timing and compliance are critical.
  • Contingencies in the Purchase Agreement: Including financing contingencies in your purchase contract can protect you if the lender ultimately decides not to finance the property. This allows you to back out of the deal without jeopardizing your 1031 exchange.
  • Loan Terms: The terms and interest rates offered by lenders can vary significantly depending on the property type and location. Securing favorable financing terms is essential to maximizing the benefits of the exchange and ensuring the long-term viability of the investment. Your primary lender may not be able to offer you the best terms, making it beneficial for you to consult with a mortgage broker.

2. Exchange Timelines

  • Strict Deadlines: The 1031 exchange process involves strict timelines, including the 45-day identification period and the 180-day closing period. If financing falls through due to the property not meeting the lender’s criteria, you may not have enough time to find and close on an alternative property, potentially disqualifying the exchange.
  • Backup Options: If your primary choice of property has financing risks, consider identifying backup properties that also meet your lender’s criteria. This can provide a safety net if the primary property cannot be financed.

3. Property Type Considerations

  • Non-Traditional Properties: Certain property types, such as raw land, specialized commercial buildings, or properties in need of significant repair, may be harder to finance. It’s important to verify in advance whether these types of properties align with your lender’s criteria.
  • Mixed-Use Properties: If the property is mixed-use (e.g., residential and commercial), ensure that the lender is comfortable with this and can offer financing that meets your needs.
  • Single Tenant Assets: Lenders may have strict financing policies as it pertains to single tenant assets if the tenant is non-credit or has limited financial information available to review.

4. Location Factors

  • Market Conditions: Lenders often assess the economic stability of the location where the property is situated. Properties in rural, economically distressed areas, or regions with high vacancy rates may be seen as higher risk, making financing more challenging.
  • Zoning and Regulations: Properties in areas with unique zoning laws or regulatory issues may face financing hurdles. Ensure that the property’s location does not pose unexpected challenges that could delay or derail the exchange process.
  • Out of State Properties / Borrowers: Many banks are hesitant to lend on properties outside their service area or to borrowers who are not within their geographic footprint. Key factors influencing these lending decisions include your existing banking relationship (such as deposits and prior loans with the institution), the size of the bank (national vs. local), and the bank’s specific policies. A mortgage broker can be especially valuable for out-of-state borrowers by connecting you with lenders who are comfortable with cross-state lending and can provide competitive terms. Additionally, out-of-state borrowers may need to make special arrangements for closing, such as signing documents remotely or coordinating with a local title company. Your mortgage broker or lender can assist in facilitating these processes to ensure a smooth transaction

5. Impact on Investment Strategy

  • Cash Flow and ROI: Securing the right financing is crucial for achieving your desired cash flow and return on investment (ROI). If the property type or location limits financing options, it may impact the financial performance of your investment.
  • Long-Term Objectives: Align the property’s financing with your long-term investment goals. For example, if you plan to hold the property for an extended period, ensure that the financing terms are sustainable over time.

6. Consult Your Network

  • Real Estate Broker: Your broker can help identify properties that are more likely to meet financing criteria, saving time and reducing the risk of complications during the exchange process.
  • Tax and Legal Advisors: These professionals can provide insight into how financing decisions might impact the overall success of the 1031 exchange and any associated tax implications.
  • Real Estate Mortgage Broker: Your mortgage broker plays a critical role in aligning financing terms with the goals of your 1031 exchange. Given the strict timelines involved, a skilled broker can provide valuable expertise and connect you with lenders who are ready to finance your replacement property. Additionally, a good mortgage broker will help reduce the stress of the 1031 exchange process by coordinating with the lender and managing third-party vendors (such as appraisers and property inspectors) to ensure everything stays on track for a timely closing.
  • Qualified Intermediary: Working closely with your qualified intermediary can help ensure that all aspects of the financing are in compliance with IRS rules. The QI can provide feedback to help structure the exchange to avoid unintended tax consequences.

Successfully navigating a 1031 exchange requires careful planning, especially when it comes to securing financing. Ensuring that your replacement property meets your lender’s criteria is crucial to complying with IRS debt and equity requirements and avoiding taxable consequences. By strategically planning before entering a contract and working closely with professionals, you can mitigate risks and ensure a smooth exchange process. These steps will not only help you meet the strict timelines of a 1031 exchange but also align your financing with your long-term investment goals, maximizing the benefits of the exchange and securing the financial future of your investment.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

CapWise Commercial Advisors, Inc. does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

About The Author
Ben Faubion is a licensed commercial real estate broker in the State of California. He is a former CPA (inactive) and has worked as an advisor at both national and regional real estate consulting firms. Ben leverages his diversified background to assist clients in creating value in their commercial real estate holdings, including investment, debt financing, and leasing.