Reverse 1031 exchange: How to tap equity for your next house

With a tight inventory of homes for sale, most folks don’t want to first sell their home and then hope to find the right replacement property. They’d rather identify the right replacement pad first, get it under contract, and then sell their departing residence.

The same is true of most property investors looking to trade property.

In the residential space, the process of buying first and then selling requires one extra step for investors to defer capital gains taxes on the sale of a property. That extra step is called a 1031 exchange — in reverse.

Before digging deeper, let me first briefly explain a 1031 exchange and a reverse 1031 exchange.

IRS code section 1031 is a tax-deferral strategy allowing real estate investors to sell investment property and reinvest the proceeds into another “like-kind” property, deferring capital gains taxes. The replacement property must be of equal or greater value, identified within 45 days and closed within 180 days.

A qualified intermediary (third party) must hold the funds from the sale to ensure the investor never directly touches the money.

A reverse 1031 allows investors to buy a new replacement property before selling the relinquishing property, while still deferring capital gains.

It requires a qualified intermediary to hold the title to the property in what’s called a Qualified Exchange Accommodation Arrangement. Because an investor cannot own both properties simultaneously for a 1031 exchange, an Exchange Accommodation Titleholder or EAT (the temporary owner) is used to park the title until the relinquishing property is sold.

For some 1031 exchangers, there is still one more big challenge: Coming up with the down payment for the replacement property before the relinquishing property is sold and escrow is closed.

One solution is something akin to a reverse 1031 bridge loan. This means tapping equity from the relinquishing property (before it’s sold) and using that equity as a down payment.

Lendsure offers a unique loan program that addresses the down payment conundrum — assuming you can’t get the down payment elsewhere. I’ve never heard of this before.

The investor takes out a first mortgage against the relinquishing property to be used as the down payment for the replacement property. The owner can take out as much as 70% of the equity in respect to California properties.

There are no payments for this loan. Interest accrues at about 8.75% with the balance being paid back when the relinquishing property sells. The loan must be paid off within 180 days (consistent with 1031 rules).

Once the loan is in place, the investor/owner gives title to the EAT.

Meanwhile the owner uses the relinquishing property loan for a down payment on the replacement property and takes out a mortgage against the replacement property.

Here’s an example:

—The relinquishing property is worth $1 million and is owned free and clear (no mortgage). The owner takes out a loan against this property for $700,000.

—The owner gives the property title to the EAT.

—The replacement property is being purchased for $1.5 million.

—The owner puts the $700,000 down on the replacement property and completes the purchase by taking out a $800,000 mortgage on the replacement property.

—The relinquished property eventually sells for $1 million. There is $300,000 in equity, minus the accrued interest and closing costs of say $30,000 for a total of $270,000 in equity.

—The EAT sends $270,000 to pay down the $700,000 replacement property loan to $430,000.

In this example, there is a prepayment penalty of $6,500 as the borrower can only pay the balance on the replacement home down by 20% of the original balance without a prepayment penalty kicking in.

—The reverse 1031 is completed using equity from the relinquishing property for the down payment.

Any investor using this system must balance the options carefully because there are significant costs involved. Points and closing costs are being charged for two mortgages.

In another reverse 1031 example, Exchange Resources charges a flat $8,000 fee for qualified intermediary services, according to Shelene Nordstrom-Vaka, the company’s vice president.

Full disclosure: My firm, Mortgage Grader, does business with Lendsure.

Freddie Mac rate news

The 30-year fixed rate averaged 6.01%, 8 basis points lower than last week. The 15-year fixed rate averaged 5.35%, 9 basis points lower than last week.

The Mortgage Bankers Association reported a 2.8% mortgage application increase compared with one week ago.

Bottom line: Assuming a borrower gets an average 30-year fixed rate on a conforming $832,750 loan, last year’s payment was $459 more than this week’s payment of $4,998.

What I see: Locally, well-qualified borrowers can get the following fixed-rate mortgages with one point: A 30-year FHA at 5.25%, a 15-year conventional at 4.99%, a 30-year conventional at 5.5%, a 15-year conventional high balance at 5.5% ($832,751 to $1,249,125 in LA and OC and $832,751 to $1,104,000 in San Diego), a 30-year high balance conventional at 5.99% and a jumbo 30-year-fixed at 5.75%.

Eye-catcher loan program of the week: A 30-year mortgage, fixed for the first five years at 5.125% with 30% down payment and 1 point cost.

Jeff Lazerson, president of Mortgage Grader, can be reached at 949-322-8640 or jlazerson@mortgagegrader.com.