1031 exchange on a property with mortgage and heloc

Investor · Central NJ, NJ · Member since 2014 · 8 posts · 2 votes

Hi all. Got a fuzzy question i cant seem to get clarity on. I own an investment property that i have a primary mortgage on. I also recently got a heloc on the property but havent drawn down on it. I am considering a 1031 but already found the next property I want to buy. If I draw down on my heloc for the downpayment of the new property will the proceeds from the sale of my current place be allowed to payback the first mortgage and the heloc?

Thank you

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Angelique Barboa

Member since 2018 · 17 posts · 8 votes

@Dave Foster excellent advice

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
10y
@Justin Palamara, If you break it down into the parts it's really not fuzzy at all. In 1031 world there is no distinction made between financing only on property use. This may have started out as a primary residence with primary residence financing but now for 1031 purposes it is simply an investment property with financing that will be paid off at close - both the 1st mortgage and the heloc.
The only thing that could potentially trip you up is if you used the heloc close to the time of sale and for a lot of personal expenses not related specifically to real estate investing. In that case the IRS could conceivably treat that as a way to access your profit ahead of time and choose to tax it. But your comment indicates that you have not tapped the heloc and when you do it will only be for the replacement property. That is totally fine.
Remember though that the statutory order of a 1031 exchange is sell followed by buy. So if you access your heloc as a down payment and purchase the new property before closing the sale of the old property you may not 1031 into that property since you now already own it.
However, if you want to tap the heloc as earnest money ahead of selling and then buying that is fine. At the closing of your sale the mortgage and heloc are paid off. You then use the remaining proceeds, the heloc earnest money, and whatever loan in addition if necessary and complete the purchase of the new property.
If you don't locate your replacement property until after the sale you can still use those funds as earnest money. At the sale the heloc wasn't tapped so it just goes away. The mortgage is paid off and the net proceeds go to your exchange account. These proceeds can then be used as earnest money when you locate your replacement property.
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Bill ExeterBusiness Member
1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
10y
Originally posted by @Justin Palamara:

Hi all. Got a fuzzy question i cant seem to get clarity on. I own an investment property that i have a primary mortgage on. I also recently got a heloc on the property but havent drawn down on it. I am considering a 1031 but already found the next property I want to buy. If I draw down on my heloc for the downpayment of the new property will the proceeds from the sale of my current place be allowed to payback the first mortgage and the heloc?
Thank you
Let me help simplify this for you. Yes, as long as the draw down from the HELOC is only used toward the earnest money deposit on your replacement property. Funds drawn down from your HELOC but used for other purposes not related to the purchase of your replacement property would likely be treated as equity not reinvested in your replacement property and therefore taxable boot. The first mortgage and the HELOC would be paid off at the closing of your relinquished property.
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Mike Dymski
Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
8y
@Bill Exeter @Dave Foster and others. Question:
$1M value existing property
$700K unusued line of credit on existing property
$1M replacement property
$300K down payment for replacement property (funded by $700K line of credit)
This appears to cause problems for the 1031 on $400K. Is there a way to structure this to eliminate that problem, for example, making an earnest deposit of $700K on the replacement property (funded by the line) (and then get a refund at closing of the replacement property to get back down to $300K of equity)? Essentially, are there creative ways to reduce equity from one property to the next?
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
8y
@Mike Dymski, Where is the $400K problem? I'm not seeing the difficulty unless you're ending up with excess equity that will end up in your pocket.
It's fine to use $300K as earnest money. You'll want to make sure it passes a sniff test for risk of loss passing and step transaction.
Is it possible to simply sell the old property and use the net proceeds as the down payment? Or is there a timing issue?
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Mike Dymski
Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
8y
Originally posted by @Dave Foster:
@Mike Dymski, Where is the $400K problem? I'm not seeing the difficulty unless you're ending up with excess equity that will end up in your pocket.
It's fine to use $300K as earnest money. You'll want to make sure it passes a sniff test for risk of loss passing and step transaction.
Is it possible to simply sell the old property and use the net proceeds as the down payment? Or is there a timing issue?
$1M sales proceeds - $300K debt on the property at closing (advance on the line for down payment on replacement property) = $700 equity - $300K invested in the replacement property = $400K problem. I don't know the equity rules; so, this may be gibberish.
Your 2nd question...a partner (and me) may not want to keep a larger amount of equity in a deal than needed. Ideally, we will purchase a higher value property but I am preparing for all scenarios.
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Bill ExeterBusiness Member
1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
8y
Hi @Mike Dymski,
You sell your relinquished property at $1.0 million with $3.0 million in debt from the line of credit, which means that you have $700K in equity at the closing. You then buy your replacement property for $1.0 million for $300K in earnest money deposit from the line of credit (cash at this point) and another $700K in equity from the sale of your relinquished property for a total of $1.0 million in total cash so that you have $1.0 million in total equity in the new property. You have reinvested by trading equal in value at $1.0 million sale of relinquished property and $1.0 million purchase of replacement property and you have reinvested all of your equity by effectively putting in $1.0 million in cash into your replacement property. I don't see a problem here.
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Mike Dymski
Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
8y
Originally posted by @Bill Exeter:
Hi @Mike Dymski,
You sell your relinquished property at $1.0 million with $3.0 million in debt from the line of credit, which means that you have $700K in equity at the closing. You then buy your replacement property for $1.0 million for $300K in earnest money deposit from the line of credit (cash at this point) and another $700K in equity from the sale of your relinquished property for a total of $1.0 million in total cash so that you have $1.0 million in total equity in the new property. You have reinvested by trading equal in value at $1.0 million sale of relinquished property and $1.0 million purchase of replacement property and you have reinvested all of your equity by effectively putting in $1.0 million in cash into your replacement property. I don't see a problem here.
Hey Bill. Thanks for taking the time to reply. The $700k will not be reinvested in the replacement property...just $300k.
I am learning that I need to put financing on the property and draw on it a year or more prior to sale. Or, pay cash for the replacement property and then refinance after closing. I'd prefer to trade up but my sources of deal flow may provide a similar priced asset and I'm just preparing for that scenario.
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Angelique Barboa
Member since 2018 · 17 posts · 8 votes
7y
@Dave Foster excellent advice
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Puri Indah
Member since 2018 · 36 posts · 11 votes
7y
Hi @Dave Foster sorry to jump into this conversation. I found this post very helpful, however was wondering if this still works for reversed 1031 exchange?
My situation:
$1,150,000 property value
$ 420,000 mortgage
$ 279,000 heloc
Can I buy a new property and use the heloc from the relinquished property as an additional down payment? (I need a much larger down payment). I understand per your posts above that this works for forward 1031. But how about reversed 1031? The 1031 guy I talked to said I can't do that.
Would appreciate your expert advice.
Thanks much!
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
7y
@Puri Indah, That could work fine. Say you wanted to buy a $2 mil property using $500K from the heloc as the down payment. You're actually going to lend that money to the QI (we'll be taking title to the property since you can't take title until your old property closes which is what constitutes the "reverse" part) for the down payment. And the lender will lend the rest of the funds also to the QI as the first mortgage. We as the Exchange Accommodating Title Holder have a mortgage to you for $500K and to the lender for $1.5 K.

When your old property sells you have to pay off all debts so the $420K mortgage and the $500K heloc are paid off at closing and approx $230 goes into your exchange account. Now you can take title to the new property. The $230K in the exchange account gets paid to you or to the lener partially satisfy the 2nd mortgage or their 1st mortgage we have with you. You agree to assume the remaining $220K in mortgage which is to yourself so it just disappears. And you assume the remainder of the first mortgage from the lender.

The one issue with this would be the fact that you are placing debt on a property closely followed by a sale. and the IRS has shown a natural distrust of this practice It's not that there is a statutory prohibition. But a refinance prior to a sale is frequently viewed as a way of taking of profit without taxation.

Your accountant may be comfortable enough with the paper trail of refi for business purposes as normal operating practice that they let the above scenario stand as is. Or you can also further mitigate exposure buy making sure that all proceeds go into the first mortgage so you don't walk away with any funds at all. Or even further mitigation would be to use the remaining $230K of proceeds to purchase a 2nd replacement property.

In both of those cases you don't walk away with any money at all so it's hard to say you accessed profit with being taxed.

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Puri Indah
Member since 2018 · 36 posts · 11 votes
7y
Lots of info. Thanks so much @Dave Foster. Hopefully I just have to do forward exchange. Since reverse exchange sounds a bit more complicated.

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
7y
@Puri Indah It's the deep end of the pool for sure. But the QI you work with is your guide through the maze of the reverse exchange and can make it relatively painless (although still expensive) process.
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Elizabeth BlazinaPro Member
Property Manager · Seattle, WA · Member since 2010 · 60 posts · 8 votes
6y
Hi all, I know this is very late and may never be read but I thought I would give it a try. So is it possible to do a 1031 where the funding is coming from a Heloc on a different property. For example, selling property at 350K, Replacement property is 750K , Using Heloc on another property as the funding for the difference in equity and new value.
Thank you,
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
6y
@Elizabeth Blazina, In order to defer all tax you must do two things - You must purchase at least as much replacement as your net sale (contract price minus closing costs). And you must use all of the net proceeds from the sale in your purchases.
The IRS does not care what the source is of any additional funds needed. You can bring in your own cash. Or take out conventional financing or use a heloc on another property. As long as you purchase at least as much as you sell and use all of the cash from the sale you'll defer all tax.
Your plan will work.
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Elizabeth BlazinaPro Member
Property Manager · Seattle, WA · Member since 2010 · 60 posts · 8 votes
6y
Thanks Dave!
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Jeff Stanners
Member since 2018 · 21 posts · 7 votes
6y
I have a different situation to ask about. Sorry to just add it on to this post from 4 years ago, but it seems to just keep going so I'll join in.
Selling property for $200k.
Buying new property for $225k.
Loan is 100k, but it's not a mortgage. I borrowed it from my dad from his insurance policy.
Can I pay him back and take out a mortgage on the new property without paying capital gains taxes?
Thank you!
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
6y
@Jeff Stanners, If you just take cash from the exchange and pay your dad back you'll have to pay tax on that as if it were profit you're taking out. And you dont have that much profit so there would be no reason to do the 1031.
If the loan is recorded against the property then the title company has to pay it off in order to issue a new title to the buyer. So that works just fine.
If the loan is not recorded (I'm betting it's not) then you've got a dilemma. You could either record it now before selling. Then the scenario above comes into play. And the optics are very transparent. But it could also look like a refinance close to a sale and you could get into weeds explaining the situation if ever audited.
Or, if it's unrecorded but the title company is willing to pay it off on the settlement statement then you've got a good argument if you kept good records on amounts/payments/amortizations etc. Then it would come down to how comfortable you and your legal folks feel about declaring that it really was just a regular mortgage that was unrecorded.
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Jeff Stanners
Member since 2018 · 21 posts · 7 votes
6y
Thank you @Dave Foster. I figured I had a dilemma as I started getting deeper into this. The loan is not recorded against the property. We did keep good records and treated it just like a mortgage. I guess I'm going to have to wait and see. Thanks for your help on this.
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Jeff Stanners
Member since 2018 · 21 posts · 7 votes
6y
Another thought on this @Dave Foster.
Could I put the full $200k towards the new property, plus come up with $25k cash and make a cash purchase. Then keep the loan with my dad and keep paying him for another 3-6 months (or some length). Then refinance the new property under a traditional mortgage and pay him back at that point. Would I avoid (legally defer) the capital gains taxes that way?

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
6y
@Jeff Stanners. Winner Winner Chicken Dinner! not only could you pay your dad back but you could also pay yourself back the $25K. A refinance after a 1031 is perfectly fine. And the money is tax free.
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Jeff Stanners
Member since 2018 · 21 posts · 7 votes
6y
Thank you for your replies. This helped a lot and relieved some stress.
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Alex Hsu
San Jose, CA · Member since 2017 · 4 posts · 0 votes
5y
Hi @Dave Foster... thanks for the answers on this thread. Lots to think about. We have a HELOC on our rental that I want to sell this year, and I guess I'm still unclear on what's allowed and not allowed to do with the HELOC in light of the exchange. Much of the balance was used to pay other debts in the past, will the IRS come after those amounts and tax them? Does it matter how old those draws are and what they were for? For example I had used another HELOC for the down payment of this rental and then used the HELOC of this property to pay that back. Is that really considered "profit"? Would the advice basically be to not touch the HELOC a year before exchanging, either drawing from it or refinancing?

Sorry for all the questions... I originally was planning on refinancing to access more equity for things like capital improvements (both for this property and others), but now I’m not sure what maneuvers would impact the exchange.
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
5y
@Alex Hsu, Unless you are accessing that heloc close to the sale of your old property it will not invite scrutiny. When you do something like that close to the sale (within the same year or so) The IRS may look at it as an attempt to take out profit ahead of the 1031 (of course if audited and examined). Even if you do this immediately prior to a sale but it is your customary business practice to access debt that way for business then it's generally not a big risk.
What would be more important is how those funds were reported. Funds used for personal use cannot have mortgage interest deducted as an investment expense. Funds used to repay a mortgage should probably be reported as mortgage interest for that property (your accountant may have a druther on that).
But unless you're accessing that heloc immediately prior to sale to take a trip to Alaska. And if you've accounted properly for the funds accessed and the associated interest you are probably fine. It would then act just like any other mortgage - It is paid off in the 1031. And you are left with the reinvestment requirements of purchasing at least as much as your net sale and using all of your cash proceeds to do that.
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Pat Daniels
Investor · Houlton, WI · Member since 2017 · 9 posts · 3 votes
5y
Late to the post. I have five properties that I plan to sell and 1031 into DST investments. I have un-tapped HLOCS on two the properties and was planning to pull funds from them to replace carpet and appliances, complete some repairs and have the units painted. Can I use the funds available in the HLOC to cover these cost accross all five properties?
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
5y
@Pat Daniels, You're in the same situation as @Alex Hsu immediately above in this string. It's not that this would be illegal in any way. But the IRS could be suspicious that you were accessing profit by tapping the HELOCs rather than leaving all the equity in the 1031. Tapping to improve properties as part of your regular business model is legitimate. You just want to keep very good records in case you ever have to demonstrate.
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