What Commercial Real Estate Investors Need to Know About Reverse 1031 Exchanges

1031 exchanges of commercial real estate

Note: In this article, we hear from guest contributing blogger Kip Dunkelberger (kdunk@venturemortgage.com), the President and CEO of Venture Mortgage Corporation.  Kip leads this trusted, dynamic commercial real estate mortgage banking firm, and he himself is known as an experienced and resourceful problem solver in the realm of commercial real estate financing.  

1031 Exchange Deadlines

Today’s savvy investors, particularly those looking to defer tax consequences by taking advantage of 1031 exchanges, are wisely looking for ways to secure a replacement property before selling the soon-to-be-relinquished property.  These investors need to know that once they close on the sale of their old property, they have a new property investment to exchange into. 

They are rightly concerned, because the deadlines for a normal forward exchange require you to identify your replacement properties within 45 days and close on them within 180 days. 45 days to identify in a hot (seller’s) market  presents a potentially formidable challenge. Here in the Upper Midwest, where the competition for choice replacement multi-family properties is particularly fierce, the process of identifying and trying to close on a replacement property in a normal forward exchange is not always a realistic possibility. That’s where a reverse 1031 exchange, combined with a creative, problem solving commercial real estate mortgage banking firm with access to a wide variety of lenders, can make all the difference.

How can Investors Step into a Sure Thing via 1031 Exchange?

Many investors are turning to these reverse exchanges to increase their chances of completing a 1031 exchange. In a reverse exchange, an investor can have their replacement property purchased for them by a qualified intermediary before closing on the sale of their old relinquished property.  The qualified intermediary (“QI”) then creates a new LLC to be the purchaser of the replacement property and holds title (or “parks the ownership”) for up to 180 days while the investor sells the relinquished property.  The ability to finance the purchase of the replacement property before you have the proceeds from your sale is where the need for innovative financing comes in.

How do the Loan Documents Change in a Reverse Exchange?

Typically, 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. This lease is subordinate to the lender’s loan, and, from the lender’s perspective, really simplifies the process by putting the investor (the lender’s actual and ultimate customer) in charge of the taking care of the parked replacement property and paying all of the bills.

In Practice: Tip # 1 – Tax Statements

At the first closing of the replacement property, on the deed from the seller to the LLC, the lower right hand portion can be filled out to tell the county to mail the property tax statement directly to the investor’s address, rather than to the QI or its LLC.  That way the investor receives the bills and statements for the property taxes directly.

In Practice: Tip # 2 - Insurance

The insurance certificate for the liability insurance should list the lender, the LLC, and the investor all as insured parties.  That way, if there is a claim, all of the parties with an insurable interest in the property are protected.

If you have questions about obtaining a mortgage or financing for a reverse exchange or any other commercial real estate investment, you are invited to call Kip Dunkelberger at (952) 843-5125, or email him at kdunk@venturemortgage.com.

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