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Exchange Blog
Second Home Rider on Loan and 1031 Exchange
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.
FIRPTA Withholding
The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) was established in order to allow the Internal Revenue Service (IRS) to collect a capital gains tax on the realized gains from the sale of real property located in the United States by foreign individuals or businesses. The FIRPTA withholding stipulates that upon the sale of real property in the United States by a foreigner, 10 percent of the property’s sales price is to be withheld at the time of the sale in order to ensure that the United States is able to collect the applicable sales tax. Before passing FIRPTA, it was much more difficult for the IRS to collect the capital gains tax because there was little recourse should the foreign individual or business be selling the property as a result of leaving the country permanently.
Deferred Taxes
Interested in deferred taxes? Internal Revenue Code Section 1031 allows that “no gain or loss when shall be recognized on the exchange of property held for productive use in trade or business, or for investment, if such property is exchanged solely for property of like kind which is to be held for productive use in trade or business or for investment.” This means when selling real or personal property held for business or investment, the federal and state capital gains and recaptured depreciation taxes can be deferred indefinitely or until the replacement property is sold.
1031 Exchange in Lieu of Foreclosure PLR 201302009
Typically, when a taxpayer sells real or personal property and realizes a gain from the sale, the realized gain is subject to payment of capital gains taxes. One option that taxpayers frequently use to temporarily avoid the payment of capital gains taxes is to enter into a Section 1031 Exchange in lieu of a traditional sale. If a transaction qualifies for Section 1031 treatment, any capital gains taxes that would otherwise be due on the realized gain are deferred.
Starker Exchange
Before the Starker Exchange Tax Court case, Title 26, Section 1031 of the Internal Revenue Code was enacted to allow the deferment of capital gains taxes on certain property transactions so long as the properties were exchanged simultaneously. In other words, the new or replacement property needed be obtained at the same time the old or relinquished property was sold. This understanding of the IRS rules made exchanging real estate very difficult, as getting all of the pegs aligned for a simultaneous exchange was not easy.