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Most 1031-exchange transactions include mortgage boot because most investors use debt leverage to acquire property. In a forward exchange, the debt element is fairly straightforward. A property-owner simply obtains new financing when acquiring replacement property.
On the Web
For more on 1031 exchanges, see Scotsman Guide's October 2009 Q&A with Federation of Exchange Accommodators Past President Hugh Pollard.
But the debt is structured differently in more-complex transactions in which an accommodation titleholder must be used. This is because the accommodation titleholder, rather than the taxpayer, must acquire and own the property while construction improvements are under way.
When an accommodation titleholder is needed, lenders have options for structuring the debt component of the exchange. These include:
Lender loans to the accommodation titleholder. Because the accommodation titleholder takes title to the parked property, the lender may make a nonrecourse loan. In this case, the accommodation titleholder signs the promissory note and security instrument, and the parked property is pledged as collateral. Because most lenders today require recourse against borrowers, the lender would then look to the taxpayer to guarantee the debt.
This is the most common structure that lenders accept in exchange transactions that require an accommodation titleholder. Should the taxpayer acquire the replacement property by deed transfer, the lender will want to modify the loan documents to reflect the change in collateral ownership. If the exchange is completed by transferring the membership interest in the accommodation titleholder, a modification typically is not necessary.
Lender loans directly to the taxpayer. A lender sometimes may not be comfortable lending directly to the accommodation titleholder. Often, this is because the lender has an established relationship with the taxpayer, not the accommodation titleholder.
In these instances, the lender may require that the taxpayer pledge assets outside of the parked property or that the taxpayer borrow directly from the lender. This might include borrowing against stock holdings or through a home-equity or business line of credit. The taxpayer would subsequently loan the borrowed amounts to the accommodation titleholder. The accommodation titleholder would execute a nonrecourse note and security instrument and pledge the parked property as collateral for the taxpayer's loan.
Hybrid structures. Sometimes, a lender may consider a hybrid structure whereby the accommodation titleholder signs the security instrument, the parked property is pledged as collateral and the taxpayer acts as the borrower on the promissory note.
The broker's role
To help their commercial property-investor clients, mortgage brokers must understand the basics of the 1031-exchange process and the applicability of various exchange strategies -- including their usefulness to accomplish green objectives. Brokers and their clients also must acknowledge the highly inflexible 180-day timing for completing safe-harbor exchanges. Unexpected delays in the debt-funding process can impact the exchange process negatively and may result in the failure of the exchange.
It also is vital that brokers communicate these issues with the lender to plan accordingly.
Further, having a working knowledge of the various exchange strategies allows brokers to understand the potential complexities surrounding the leverage for the transaction. Brokers who propose these strategies proactively can provide more value to their clients and garner loyalty.
Note: This article was written for educational and informational purposes only and should not be construed as legal or accounting advice. Advise your clients to consult an attorney or certified financial planner to determine what is legal and appropriate for their specific situation.
Ricky B. Novak,
president of Strategic 1031 Exchange Advisors, is a licensed attorney in Georgia. He received 2009 Georgia Super Lawyers Rising Star and GeorgiaTrend Legal Elite honors. Reach Novak at (678) 522-8801 or firstname.lastname@example.org. Chief Financial Officer James W. Freeman is a licensed certified public accountant. He was the Georgia Society of CPAs' Outstanding Member in Industry for 2009. Reach Freeman at (678) 481-3359 or email@example.com. Visit www.sea1031.com or call (888) 800-1031.
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