Fundamental to a 1031 exchange is the requirement that the replacement property be held as an investment property; not as a second home. The property can be converted to a second home, but only after it is first held as an investment. Often loan and deed of trust documents reflect a second home rider clause stating the property cannot be rented out or placed in a rental pool. Caution, beware, “Houston we have a problem” or at least discuss with your financial advisor. Continue reading to recognize whether your Deed of Trust contains a Second Home Rider typically found at the end of the loan agreement.
Second Home Rider
“Occupancy. Borrower shall occupy, and shall only use, the Property as Borrower’s second home. Borrower shall keep the property available for Borrower’s exclusive use and enjoyment at all times, and shall not subject Property to any timesharing or other shared ownership arrangement or to any rental pool or agreement that requires Borrower either to rent the Property or give a management firm or any other person any control over the occupancy or use of the Property.
Borrower’s Loan Application. Borrower shall be in default if, during the Loan application process, Borrower or any persons or entities acting at the direction of Borrower or with Borrower’s knowledge or consent gave materially false, misleading, or inaccurate information or statements to Lender (or failed to provide Lender with material information) in connection with the Loan. Material representations include, but are not limited to, representations concerning Borrower’s occupancy of the Property as Borrower’s second home.”
Scenario
Imagine you have closed on your old property, communicated with your lender the intent to hold the property as an investment and now with your replacement property closing scheduled tomorrow you receive a phone call from your lender alerting you that the loan must be revisited or additional fees and a higher interest rate must be assessed. Why after all the effort complying with lender regulations, countless emails and follow ups is a change required at such late notice?
Higher Loan Fees and Interest Rate
This happens even after a 1031 exchange was explained, including providing a copy of the Delayed Exchange Agreement and relinquished settlement statement clearly indicating a 1031 exchange to the loan processor. If the loan does not need to be revisited, the lender may say the loan can go forward but with a higher interest rate. The issue appears to be the loan is processed as a second home and not an investment property even after the taxpayer has explicitly indicated it is not. The lender must perceive a risk quantified by a higher interest rate.
Outcome Options
The outcome could be for the closing to be rescheduled. But what if the Seller and Realtors are already frazzled after a lengthy negotiation, pushing the close date is not an option? Why at the eleventh hour would the lender red flag the loan? Why wasn’t the loan clearly marked as a 1031 exchange and the appropriate interest rate quoted, verified and in writing from the start?
Constructive Receipt
Let’s say the taxpayer elects not to continue their 1031 exchange after closing on the old property and wants their exchange funds returned. In another words, the taxpayer elects to forfeit the tax deferral effectively canceling the 1031 exchange to close on the property they worked so hard to find, negotiate for a low interest rate … only to learn there is another issue. Once entering a 1031 exchange, the exchange proceeds cannot be returned directly to the taxpayer until the 46th calendar day post relinquished or old property closing. Talk about adding salt to the wound.
What if the taxpayer has elected a reverse exchange, title of the old property has been parked with the Exchange Accommodator Titleholder, reverse exchange documents are in place and the closing has already been pushed, causing the Seller to be anxious and not agree to reschedule? What are the Buyer’s options? I am not making this up.
Allow the loan officer to revisit the loan to change the interest rate and remove the second home rider, reflecting the loan as it was always intended for an investment property. If the Seller is not willing to wait and there is no support from the Realtors, then forfeit the tax deferral and acquire as a second home. Or when the old property is sold, acquire a replacement property to defer the capital gain. But owning two properties may not be the desired outcome.
The scenarios described happen. From the 1031 perspective, the loan documents are between the taxpayer and the lender. The Qualified Intermediary does get involved in the loan process but only in reverse exchanges when the property parked with the Exchange Accommodator Titleholder is on title. Contact your financial advisor and seek their counsel. The loan may have the Second Home Rider and as long as you are making the loan payments, the lender may not care, but then again they may, in which case paying the higher interest rate is a decision for the taxpayer and finacial advisor to make, not the Qualified Intermediary.
Must Haves
- When applying with for a loan, be sure to state that the replacement property is to be held as an investment to qualify for a 1031 exchange.
- Submit a letter to the loan officer clearly stating the intent to secure the loan to acquire a replacement property in a 1031 exchange.
- Follow up with the loan processor or officer before the scheduled closing to confirm a second home rider is not attached to the loan.
- Trust, but verify.
Learn “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking here.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
