Reverse 1031 Exchange: What a Lender Should Know

The majority of 1031 tax deferred exchanges are forward meaning that the old property is closed on before the new property is purchased. However, sometimes it makes sense to initiate a reverse exchange when the new property is acquired first and the old or relinquished property is sold later. Successful completion of a reverse exchange requires the participation of an Exchange Accommodator Titleholder (EAT) that takes title to either the new or the old property because the Internal Revenue Service does not allow the taxpayer to own both properties at the same time. What happens if a mortgage is required for the new property? What should a lender know before a loan approval process? The answer to that question depends on the type of a 1031 reverse exchange that was initiated.

Reverse First

An EAT is created in the entity form of a single member limited liability company to take title to either the new or the old property. The taxpayer has a secured position in the EAT through a Pledge of Membership Interest from the EAT member to the taxpayer.

In a reverse first, the old property is parked with the EAT. Prior to the closing on the new property, a deed is created conveying title from the taxpayer to the EAT. If a mortgage exists on the old property, the taxpayer continues to make payments. The taxpayer is responsible for taxes, insurance and expenses on the old property throughout the time owned by the EAT. The old property is marketed and sold to the buyer as normal. At the closing, the property is conveyed from the EAT to the buyer. Net proceeds from the sale are wired to the taxpayer.

Reverse Last

In a reverse last, the new property is acquired by the EAT on behalf of the taxpayer. If a mortgage is required for the new property, the EAT will sign a non recourse note with the lender. It is important to know before the loan application gets to the loan committee that the transaction is part of a reverse 1031 exchange. Once the loan is approved, it can be a challenge to re-do the loan approval process given the EAT will temporarily be on title.

Once the old property is sold, the title for the new property is conveyed to the taxpayer. This can be done through a warranty deed. If the state assesses a transfer tax, the EAT can also be conveyed to the taxpayer, consequently the title does not change, just the member of the EAT.

What the Lender Should Know

Which property will be parked or titled to the EAT? If the new property is parked, then be sure to involve the EAT in the loan approval process. If the old property is parked with the EAT, the existing lender will not be aware of the temporary title change given there is no interruption of mortgage payments.

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