Finding §1031 replacement property financing solutions

For many investors seeking to perform a §1031 tax deferred exchange, the biggest challenge in today's market is obtaining financing to acquire the replacement property. This issue can be solved in a number of ways that do not involve having to go through the hurdles and process of obtaining new financing for the acquisition. Seller financing is one way investors are obtaining the necessary funds today. As long as the investor is trading up or equal in value and investing the entire net equity derived from the sale of the relinquished property into the replacement property, seller financing will not adversely affect the investor's ability to 100% defer his or her capital gain taxes. Note that if the seller is also an investor seeking to do a §1031 exchange, special issues arise and must be addressed in order to 100% defer his or her taxes. As to the investor buying replacement property from a seller who is financing the purchase, the financing is simply treated as would be a third party conventional mortgage for §1031 purposes. Thus, the amount of the seller financing would be taken into account in determining whether the investor has traded up or even in value as the value of the purchase would be the purchase price of the replacement property which would obviously include the portion being financed by the seller. Another method of obtaining financing that will not adversely affect the ability of an investor to perform a §1031 exchange is to have the investor assume existing debt on the replacement property. This is popular today where the rate is favorable and the loan documents permit assumption or the lender is willing to allow an assumption. While the investor must still qualify for the loan in this instance, the lender already has a mortgage on the property and thus has already underwritten it and completed its due diligence of the property. Again, it is important to the investor's ability to 100% defer his or her capital gain taxes that the amount of the outstanding loan being assumed permit the investor to reinvest his or her entire net equity from the sale of the relinquished property into the replacement property at closing. Presuming the replacement property is roughly equal in value to the relinquished property, this would require that the amount of the loan being assumed not exceed the amount of the mortgage debt on the relinquished property. To the extent it does and cannot be paid down at closing, the investor will likely have unspent equity from the sale that will be taxable unless used to buy additional replacement property. A final method of obtaining financing and in addition to being a good source of replacement property is to invest in a fractional ownership, such as a tenant in common program (TIC) program or Delaware Statutory Trust (DST). While a complete discussion of the pros and cons of these programs is beyond the scope of this article, these programs basically involve the sale of a fractional ownership interest in a commercial property with other investors who each reap a pro-rata share of the profits and losses of the investment. The property is generally owned by a well known real estate owner/operator who will have already arranged for the financing to fund the purchase and may have already closed on the purchase of the property and the financing. As a result, investors who elect to purchase a fractional ownership interest do not need to separately obtain financing for their purchase. While they will still need to qualify as a borrower, the lender will have already conducted complete due diligence on the property and either funded or be prepared to fund the loan in full. Thus, many of the obstacles involved in obtaining financing in today's market are removed. In addition, the investor exchanging into such programs will automatically acquire an interest valued at the total amount of the equity invested and such investor's pro rata share of the debt encumbering the entire property. For example, if a property is 50% leveraged and an investor invests $400,000 of equity into a TIC interest in such property, the investor will acquire replacement property valued at a total of $800,000. Thus, TIC programs cannot only ease the problem of financing but also can be customized to meet an investor's individual equity and debt requirements making it easier for the investor to meet the exchange equation and thus, defer all capital gain taxes. As with all investments, investors should consult their legal and tax advisors before proceeding. Pamela Michaels, Esq., is an attorney and VP of Asset Preservation, Inc., Manhattan, N.Y.