A 1031 exchange may be an appealing option for some investors, but there are many rules that you must comply with before you can enjoy the tax deferral benefits. Given the structure of a like-kind exchange, it may seem like loans are unnecessary. However, there are cases when you have to borrow funds, especially when timing and liquidity become issues.
In this article, Realized 1031 dives deeper into the ins and outs of a 1031 exchange loan. We will discuss scenarios where such a process may be necessary and the rules and considerations to keep in mind before committing to a 1031 loan. Keep reading to learn more!
A Typical 1031 Exchange
1031 exchanges are a type of investment process that allows you to swap “like-kind” properties to defer capital gains taxes. In a typical scenario, you sell the relinquished property first before you acquire a new one. You’d already have the capital to purchase the like-kind property after the property sale.
The main concern of the traditional route is the IRS rules on 1031 exchanges. One of the most prominent ones is the 180-day rule, a mandate that requires you to finish the acquisition of the replacement property within 180 days of the sale of the relinquished property. If you fail to identify and purchase a new asset after this timeframe, then you will need to pay capital gains taxes.
To help avoid this scenario, some property owners may opt for a reverse 1031 exchange. This happens when an investor buys the like-kind property before they relinquish the current asset. While this practice effectively eliminates worries about adherence to the set timeline, investors might not have the immediate funds needed for the new purchase. This is where a like-kind exchange loan becomes necessary.
What Is a 1031 Exchange Loan?
A 1031 exchange loan is a type of short-term financing that helps investors bridge the funding gap when purchasing a like-kind property. These loans are particularly helpful in reverse 1031 exchanges, especially if you don’t have other sources for funding the property acquisition.
Given this means to purchase the identified property, you can eliminate the need to adhere to the IRS’s 180-day timeframe. Otherwise, delays or funding shortfalls can jeopardize the exchange, leading to immediate capital gains tax liabilities.
Types of 1031 Exchange Loans
There are a few kinds of 1031 exchange loans, each option having features that make them more suitable for specific needs and preferences. Here are some of the popular types.
Bridge Loan
A bridge loan is the most straightforward 1031 exchange financing scheme. As the name implies, this financial solution acts as a temporary bridge between the sale of your relinquished property and the purchase of your replacement property.
There are two main advantages to a bridge loan. First, this option is typically the easiest to secure. Lenders don’t have many requirements for such an arrangement, making the loan ideal for time-sensitive exchanges. The next benefit is the flexible terms, with lenders typically requiring you to pay only once you’ve sold your relinquished property.
The main drawback of a bridge loan is the potentially high interest rate. Since this option is considered short-term financing, a lender may impose higher rates in return for the convenience the loan provides.
Hard Money Loan
Another popular option is the hard money loan. In this scenario, the loan you secure depends on the value of a property or other hard, tangible asset instead of your creditworthiness.
Hard money loans are another type of short-term financing scheme, with many similarities to bridge loans. For one, approval and disbursement can happen quickly. However, rates can also be high due to their short-term nature and the risk.
The major difference between bridge loans and hard money loans is that the latter isn’t offered by traditional lenders. Instead, it’s private companies and other investors that provide the funding.
Equity Loan
An equity loan takes the existing equity of a property to fund the like-kind swap. This option is also called a home equity loan or line of credit. Given this scheme, an equity loan is similar to a hard money loan in how it leverages the existing value of an asset. However, an equity loan is limited to real estate property. As such, the amount you can borrow is determined by the value of the property you currently own.
Rules and Considerations
Leveraging financing solutions can help make a 1031 exchange easier. However, you must stay aware of the rules and special considerations to avoid trapping yourself in a sticky financial situation. Here are a few things to keep in mind.
- Work With a Qualified Intermediary: Your qualified intermediary will oversee the entire exchange, ensuring that you’re adhering to IRS rules. This entity will also serve as the exchange accommodation titleholder as you work to sell your relinquished asset.
- Loan Terms and Rates: Before committing to a loan, you’ll want to ensure that the interest rate, repayment period, and terms align with your financial goals and cash flow.
- Debt Replacement: You’ll have to make sure that the sales price of the property matches the loan to maintain the tax-deferred status.
These are just some of the top considerations. We recommend working with 1031 exchange experts, tax advisors, and finance professionals to better understand these loans and how they can affect your taxes in the future.
Wrapping Up: The Basics of 1031 Exchange Loans
Like-kind exchange loans can serve as a tool to avoid the timeframe of the IRS or secure an asset before someone else can take it. As such, taking a 1031 exchange loan becomes a useful strategy for reverse 1031 exchanges. Before you commit to this route, you must first understand the options available as well as the advantages and risks you may encounter. Follow the primer we shared and consult with our team today to gain a more in-depth idea of these loans.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
