In a typical 1031 exchange, the replacement property will be titled in an LLC (exchange accommodation titleholder) that is 100% owned by the QI for up to 180 days. This significantly changes the way the loan documents are prepared by the lender for a reverse exchange:
Mortgagor Changes
The QI’s LLC has to be the mortgagor on the mortgage (because it is the title-holder or owner of the encumbered property), and the investor merely guarantees or co-signs the loan. Thankfully, one of the “permissible agreements” that is specifically allowed by the IRS in Revenue Procedure 2000-37 is that the taxpayer doing the exchange can guarantee some or all of the obligations of the LLC, including secured or unsecured debt incurred to acquire the property.
Due-on-Sale Clause Changes
At some point in the 180 day period, the QI will assign 100% of its membership interest in the LLC to the investor to complete the 1031, or alternatively, the LLC will deed the replacement property directly to the investor (subject to the lender’s mortgage). Typical, run-of-the-mill loan documents prohibit any part of the encumbered property from being sold or transferred, so when completing a reverse exchange, the lender needs to change the due-on-sale clause to allow the LLC to transfer the parked replacement property to the investor.
Prepayment Allowed
Most institutional commercial loans come with pre-payment penalties or restrictions on making any extra principal reductions. In a reverse exchange, the QI is going to receive the net-proceeds from the sale of the old relinquished property. In order to defer the taxes, this money needs to be re-invested into the parked replacement property before the property is given to the investor to complete the exchange. The QI needs to have the right in the loan documents to make a principal pay-down of the debt to the Lender so that, from an accounting perspective, all of the equity from the old property is redeployed into the replacement property.
QI not Liable for the Loan
When a QI is assisting an investor by having its LLC take title to the parked replacement property, it is doing so as an accommodation for the investor, not as an economic participant in the deal. The QI should not be expected to have any real liability for the representations, warranties, or indemnities in the loan documents. That being said, the lender may require the mortgage to be stated as full recourse to any borrowers, guarantors or co-signers, ensuring proper risk protection for said lender during the interim time period.
Investor Leases the Parked Replacement Property
While the LLC is the official owner of the replacement property for tax purposes, the IRS allows the day-to-day responsibilities of ownership to be shifted to the investor though a triple-net lease from the LLC to the investor. This means that during the 180 day grace period, the lease can provide that all loan payments, taxes, insurance, and any other carrying costs will be paid directly by investor.
Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.
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