How does a 'Deed in Lieu / Subject To' work with 1031?

Question

I am selling my investment SFR and executing my first 1031 exchange. I have been approached by other investors offering to take over my low rate mortgage and pay out my equity in cash in exchange for a deed in lieu. Is this a valid sale transaction in the scope of a 1031 exchange?

Thanks!

Wayne Brooks · Answer

@Ryan Laiola Yes, as @Chris Seveney mentioned, there is no deed in lieu here.

In a sub2, you transfer title to the buyer, he pays you your cash difference for the equity, and makes the payments to your lender….but, the loan stays in your name, you are liable for it if your buyer doesn’t pay, and you have No right to foreclose if the buyer doesn’t pay….for the Entire remaining term of the loan.  And if You don’t pay the mtg, You get foreclosed on.  You also have a “due on sale” issue, the lender can call your loan due if you transfer title.  I would Never sell a property sub2, for this reason.

If you do decide to seller finance to the buyer, structure it as a wrap around mtg instead.  You still have the due on sale issue, but at least you have some control through the right to foreclose and get the property back.

Perhaps more importantly, if it is the buyer who mentioned the term “deed in lieu” in conjunction buying the property sub2, then either they have no clue what they are doing or they are trying scam/dupe you somehow.

Also be aware, the reason most people are trying to buy sub2, especially if he has cash for your equity/down payment, is because they can’t qualify for a loan themselves, which is a red flag.

Chris Seveney · Answer

@Ryan Laiola

This doesn’t make sense. A deed in lieu is a deed in lieu of foreclosure and is executed between you and your lender.

A deed in lieu is where you surrender the property to the lender and they wipe the mortgage and note.

Subject to and deed in lieu don’t go hand in hand.

Also if you were to 1031 you won’t have any proceeds to 1031 except their down payment ?

Bill B. · Answer

Are they paying 20-30% over market value? If not, why would you sell to them instead of all cash?  You’re taking a massive risk. What if they never make one payment after it’s in their name? Or the loan gets called because the bank doesn’t like having a below market loan to a non-owner occupant? You’ve already acknowledged this is probably a guru student if they’ve already not sure of the terms and don’t have the credit to get their own loan.

Let say this is a $200k property and you owe $150k. I’d want at least $225k with $75k down MINIMUM to make the risk worth it, but that’s probably not enough. Getting 25k split over 30 years of risk doesn’t sound so great. It’s good for the buyer, not so good for you.

Do you qualify for a 2nd loan without this one being paid off?

What happens to your 1031 if you end up foreclosing and taking this one back?

Dave Foster · Answer

@Ryan Laiola, Good analysis by @Wayne Brooks.  The 1031 starts with you relinquishing an investment property.  Normally this event is when the deed transfers from the seller to the buyer.  This is the easy to identify point when the burdens and benefits of ownership have transferred.  "Risk of Loss..." has passed from the seller to the buyer.

But it is those two concepts - "Risk of loss passing" and the transfer of "Burdens and benefits of ownership" that determine if the property has been relinquished by the seller.  The deed transferring is the easiest way to tell.  But a land contract or a sub2, if the deed doesn't transfer, can also be eligible for a 1031 exchange.  If, you and your advisors determine that the burdens and benefits have transferred.  In this case the 1031 would start with the day that the contract is executed.

Wayne Brooks · Answer

@Ryan Laiola Well, I suppose you still could if you follow the 2 basic rules for a 1031….

1) the price of the replacement property must meet or exceed the sale price of the sold property

2) use all the cash received from the sale of the first property and put it into the second property

Example…

Your sale: $50k cash down payment with you carrying a wrap mtg of $100k equals a sale price of $150k.  If your actual sales costs were $10k….your replacement property would have to be at least $140k ($150k minus $10k) and use all of the $40k ($50k minus $10k), or more, toward the purchase of the replacement property.

@Dave Foster. ??

Ryan Laiola · Answer

Thank you @Chris Seveney and @Wayne Brooks for the quick replies.

The investor that approached me used the term "deed in lieu" and "subject to" and I was under the impression that the "deed in lieu" was the mechanics of deed transfer to accomplish a "subject to".  I think my understanding is incorrect on this.  I've had other conversations with the potential buyer and they seemed to clarify that their proposition is a "subject to" and are proposing a "wrap around mortgage" to help secure up the payment default risk which seems to take some risk off the table from a Seller standpoint.  Even with a "wrap around mortgage", there is still Due on Sale risk, from my original mortgage holder. However, I would imagine that Banks will become more active in this realm of calling in loans upon seeing any activity of a deed transfer in order to bring their yields back up to much better rates.

The proposed sale structure was to pay cash for my current equity and sell the property "subject to" or "wrap around mortgage" the 1st lien.  My question is still, would this structure allow for a 1031 exchange for me (seller)?  My limited understanding is that it would not, based on the concept of the debt carryforward concept of the 1031 exchange rules.  Meaning, how can the IRS track my existing debt on my sold property, whereby I need to have that same amount of debt or more, on the upsized new property that I would buy within the 1031 time frame?

How does a 'Deed in Lieu / Subject To' work with 1031?

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