Financing a 1031 exchange replacement property

The decision

A 1031 replacement purchase is an ordinary acquisition loan with two extra constraints: the exchange deadlines and the debt you need to replace. The right lender is the cheapest one that will certainly close in time, at a loan size that keeps the exchange whole.

The two constraints

Time. The regulation sets two clocks that both start when you transfer the old property: you have 45 days from the transfer of the relinquished property to identify replacement property¹, and you must receive it within the earlier of 180 days from the transfer or the due date, with extensions, of that year's tax return¹ (26 CFR 1.1031(k)-1(b)). The identification list is capped too: up to three replacement properties regardless of value (the 3-property rule)¹, or any number of properties whose combined value does not exceed 200% of the relinquished property's value (the 200-percent rule)¹. Missing either clock can end the exchange. Your financing has to fit inside the exchange period, and your identification list has to include properties you can actually finance.

Debt. When you sell, the old mortgage is paid off at closing. To defer the full gain, the replacement purchase generally has to carry at least that much new debt, or you add cash to make up the difference. Your qualified intermediary and tax adviser set the target; your lender has to meet it.

Lenders ranked for a 1031 buyer

Rank	Lender	Why	Watch for
1	Bank you already work with	Fastest commitment, knows your file	Recourse; shorter term
2	Non-bank DSCR lender	Fast, qualifies on the property’s rent	Higher rate; prepayment terms
3	Fannie Mae small loan (apartments)	Long fixed rate, non-recourse	Needs early application; lock and third-party timing
4	CMBS conduit	Non-recourse on commercial property	Defeasance; slower close
5	Life company	Best rate at low leverage	Slowest; selective on property
6	Bridge loan	Closes when others cannot	Second refinance and its costs

Agency rate locks can work in your favor here: Fannie Mae offers 30- to 180-day rate lock commitments². Smaller Fannie Mae loans also use lighter reports (Streamlined inspection and environmental screening (ASTM E-1528-14) instead of full reports), which shortens the critical path.

Worked example: replacing the debt

Illustration. You sell a building for $3,000,000. The $1,200,000 mortgage is paid off at closing and selling costs are $150,000, so the qualified intermediary holds $1,650,000. You buy a $4,500,000 replacement property with $292,500 of NOI.

Line (illustration)	Amount
Replacement price	$4,500,000
Exchange equity from the intermediary	$1,650,000
New loan needed (before buyer closing costs)	$2,850,000
Loan to price	about 63%
Debt service at 6.50%, 30-year amortization	about $216,000
Coverage	about 1.35x
Largest loan at 1.25x coverage	about $3,085,000

The new $2,850,000 loan is well above the $1,200,000 paid off, so the debt side is covered, and the lender’s coverage test leaves room for closing costs. If the replacement property had lower NOI, the coverage test could cap the loan below what the purchase needs, and you would have to add cash. Check yours with the DSCR calculator before you identify properties.

Ownership structures lenders treat differently

• Single LLC buyer. The cleanest case for every lender.
• Tenancy in common. Several exchangers buying one property together. Many lenders limit the number of co-owners. Freddie Mac’s Conventional Small term sheet caps tenants in common at a small number, for example.
• Delaware Statutory Trust. Freddie Mac’s Conventional Small term sheet lists DSTs as an ineligible characteristic. Other lenders will finance a DST sponsor’s purchase, but the sponsor arranges that loan, not the individual investor.
• Reverse exchange. The titleholder owns the property until you sell the old one, which narrows the lender list. See the FAQ below.

Timeline: line up the loan before you sell

When	What to do
Before listing	Talk to your qualified intermediary and tax adviser about the debt and value targets
Before the sale closes	Get a lender’s term sheet on the kind of property you will buy, and confirm the lender can close inside the exchange period
During identification	Identify properties your lender has pre-screened; order the appraisal and Phase I as soon as one is under contract
Before the deadline	Close the loan with time to spare for a late appraisal or title issue

A Phase I has its own clock: A Phase I must be done within 1 year before acquisition, with interviews, lien and records searches and site visit updated within 180 days⁴. Order it with the appraisal so neither becomes the long pole.

Documents

• The exchange agreement with your qualified intermediary, and the closing statement from the sale.
• Purchase contract, rent roll, operating statements and leases for the replacement property.
• Your entity documents. If the buyer must be the same taxpayer that sold, make sure the borrowing entity matches what your tax adviser signed off on.
• Personal financial statement and schedule of real estate owned.

Pitfalls

1. Choosing a lender after you sell. The clock is already running. Get the lender committed first.
2. Identifying properties you cannot finance. Pre-screen each with your lender.
3. A loan that is too small. Coverage tests at today’s rates can shrink the loan below what the purchase needs. Plan the added cash.
4. Changing the borrowing entity late. A lender may want a new single-purpose LLC; your tax adviser must confirm it does not break the exchange.
5. Bridge without a plan. If a bridge loan saves the deadline, price the second refinance now.