1031 Exchange With a Renovation Loan?

Question

My wife and I are currently under contract to sell a rental we have for $161k, our cash out of the deal will be $80k. We understand that we have to purchase at least $161k worth of replacement property and the entire $80k has to be reinvested into the replacement property.

My question is, can we use a renovation loan for the replacement property if the replacement property's purchase price is over the $161k?

Example: we buy a replacement property for $200k, it needs $100k worth of renovations, and has an ARV of $400k. We put the $80k down for the purchase but then immediately receive the $100k for the renovation.

Is this ok?

Chris Samson · Answer

@Dave Foster, thanks for responding so quickly! So we would put the $80k down on the $200k purchase and have a first note for $120k. Then we take a second note immediately out for $100k?

That makes sense, kind of like refinancing to pull cash out except we are just doing it before the rehab instead of after the rehab.

Dave Foster · Answer

@Chris Samson, You've got the gist of things well.  Your scenario is a thorny one.  On the one hand it makes sense.  But the IRS has been very clear that any cash received at a closing with very few exceptions such as a return of earnest money is considered first to be profit.  so you run the very real risk of that 100K in cash as being counted as taxable boot.

The answer to this is to have the lender create two notes.  Apply the first note to the purchase and close the property.  Then immediately after closing (and I mean really just pick up another pen at the same table) and sign the new note.

This keeps the settlement statement clean with no boot issues at all.  The second note is after recording and is viewed as borrowing against equity rather than accessing profit.