The Silvano Group

What we are talking about is financing for an investment property that needs rehabilitation (a rehab, a foreclosure, a handyman special, a renovation project, a fixer-upper, a condemned home, etc.). We will review how an investor can purchase and rehab a property using various financing methods.

Before we discuss the different ways to finance investment properties and the pros/cons of each method, we will need to review some of the factors to consider when investing in rehab properties. More often than not, there will be competition when making an offer. Often times, the sellers will be banks looking to sell off their portfolio of foreclosures in order to rid their balance sheets of non-performing assets. Sellers not only want the highest offer to maximize their profit, the seller wants to be certain the buyers financing is solid. We all know that a pre-approval letter isn’t always worth the paper it is written on. However, when the buyer knows their financing is solid they can be bold enough to make their earnest money deposit non-refundable. This alone shows the seller that you or your client you are a professional buyer and that your offer is real (this is the best pre-approval I know of). Often times, this is the difference in a competitive offer scenario.

Let’s now turn to the many ways to finance rehabs. This financing should include funds for acquisition of the property, renovation costs, and closing costs. Some of these methods will not surprise you but you will have clarity as to the best financing method upon conclusion.

1. CASH: Cash is king but only if you have it. It’s that simple. Cash helps on offers because you do not need a pre-approval letter, however, you should be prepared to provide proof of funds. The negative side of using cash is that you are tying up your personal assets until the property is sold or refinanced.

1. LINE of CREDIT: If you already own real estate with substantial equity than this is the next best thing to cash. Be prepared to show proof of your line of credit when requested by seller.

1. A PARTNER: You may have a partner who has cash – other people’s money (OPM) at it’s finest. The down side is that you have to split the profits and probably do most of the work. This has the potential of a marriage a 50/50 chance for divorce. In addition, you do not have the security of knowing the funds will be available since the funds are not yours. Partners often times will get cold feet prior to closing and back out of the loan.
2. BANK FINANCING: Yes, there are loans available from banks for purchase rehab money only. Usually, these are local banks and it’s always good to have a relationship with a local banker especially as you move on to bigger and better projects. In order to qualify for this type of financing, you must have a good credit history, a good debt-to income ratio, and good tax returns for two years. The downside is that they will require tons of paperwork, the process will be long and drawn out, and lastly you will have to come up with at least 20% of the purchase and 100% of the renovation costs plus all of the closing costs. Not bad if you have money lying around, you are patient, like paperwork, and don’t mind making monthly payments on a vacant house. Like any real estate financing, the lender will limit you to a loan to value (LTV) but in this case it will be calculated off of the after repaired value (ARV) (LTV’s are rehab loans are usually 70-80% of the ARV). The will usually have a six month term on this type of loan which would also be the case in the following types of loans as well. Six months is plenty of time to renovate and sell or refinance the loan.

1. HARD MONEY: You can borrow 100% of your purchase, renovation and closing costs. These are great loans because they are “NO MONEY DOWN” loans. One of the best ways to use OPM. The downsides are that these local deep pockets individuals who will loan you this money are expensive!!! Expect to pay no less than 10 points (a 10% fee added to the loan principal) and no less than 15% interest. Not bad if you consider that it is a cost of doing business and in most cases this is not a concern because you found a motivated seller and you will still have some great equity left in the property. As with Banks there will be an LTV (loan to value) usually 65-75% of the subject to value. THE REAL DOWNSIDE to this type of loan is the monthly payments that will be required. These payments can be pretty steep especially when you consider that the property is vacant and no one is paying rent while you are renovating and marketing to sell or in the process of refinance. These lenders will give you between three to six month loan term. They charge high fees (typically an additional 5 points) for loan term extension. They are however more lenient than the local bank regarding paperwork and sometimes on the credit score minimum.

Overview

All sales and exchanges are taxable, unless a specific provision of the Internal Revenue Code (Code) says that the gain or loss is not recognized. Section 1031 of the Code is one such provision. The rationale is that when a taxpayer exchanges an asset for another asset that is “like-kind” to the one disposed, there is a continuity of investment, and the taxpayer should be able to defer payment of the tax. The tax is deferred by a “carryover” tax basis into the new asset. The gain would be taxed later upon a sale or exchange in which no “non-recognition” rule applies. A simple principle, but there are many Regulations, court decisions, and IRS pronouncements one must know to gain a working knowledge of Section 1031 exchanges.

Key Concepts

Qualified Intermediary

A Qualified Intermediary (QI) is a person, other than a disqualified person, who enters into an Exchange Agreement with the Taxpayer and receives and transfers (or is deemed to receive and transfer) the Relinquished and Replacement Property. The QI must receive the proceeds from the sale of the Relinquished Property, and the Taxpayer cannot have actual or constructive receipt of the proceeds during the Exchange Period, except to acquire identified like-kind Replacement Property and certain transactional expenses. Typically, a QI does not take actual title to either the Relinquished or Replacement Property. Under the Regulations, the QI is “deemed” to acquire ownership when the QI receives an assignment of rights from the Taxpayer and contract seller of the Relinquished Property (if different) and another from the contract seller of the Replacement Property. Notice of the assignment of rights is given to all parties to the contract, and then title to the property is directly deeded to the buyer (for the Relinquished Property) or the Taxpayer or its nominee (for the Replacement Property).

Identity of the Taxpayer

The Taxpayer selling the Relinquished Property must be the same Taxpayer for federal income tax purposes acquiring the Replacement Property. This issue occurs frequently in partnerships, tenant-in-common arrangements considered as partnerships, and in mid-exchange corporate reorganizations. Use of single-owner entities to acquire Replacement Property that are disregarded as separate entities from the owner, such as single member LLCs, will not change the identity of the Taxpayer.

Disqualified Person

A disqualified person is a person other than an agent of the Taxpayer. Certain persons, such as an employee, attorney, accountant, real estate agent or broker, investment banker, or investment broker are deemed the Taxpayer’s agents for a period of two years. There is a safe harbor against agency for “routine financial, title insurance, escrow, or trust services for the Taxpayer by a financial institution, title insurance company, or escrow company.” There is another safe harbor against agency for “services for the Taxpayer with respect to exchanges of property intended to qualify for no recognition of gain or loss under Section 1031.”

A QI can also be disqualified by being “related” to the Taxpayer. There are many relationships that could cause a QI to become related to the Taxpayer, such as serving as a trustee or fiduciary for the Taxpayer.

A QI can also be disqualified as a result of being related to a person or entity that is an agent (or deemed agent) of the Taxpayer. Currently, there is an exception for this type of disqualification applicable to a bank QI or a bank-owned QI when the reason for disqualification for the QI would be that the QI is related to an affiliate that performed investment banking or brokerage for the Taxpayer.

The penalty for using a disqualified person as a QI or EAT is the loss of the safe harbors, and likely a failed exchange. If there is any doubt about other activities that a QI or an affiliate of the QI is an agent, the Taxpayer should use an independent QI or EAT.

Exchange Accommodation Titleholder

An Exchange Accommodation Titleholder (EAT) is a person, other than a disqualified person, who enters into a Qualified Exchange Accommodation Agreement (QEAA) with the Taxpayer and acquires “qualified indicia of ownership” of either the Relinquished Property (in an “Exchange First” reverse exchange) or the Replacement Property (in an “Exchange Last”) reverse exchange. The Taxpayer must identify Relinquished Properties (in an “Exchange Last”) transaction within a 45-day Identification Period, and the EAT must dispose of the Relinquished Property (in an “Exchange First” reverse exchange) or the Replacement Property (in an “Exchange Last” reverse exchange) within 180 days of the day that the EAT acquires qualified indicia of ownership of the parked property. Revenue Procedure 2000-37, 2000-2 C.B. 308 establishes a safe harbor for both Exchange First and Exchange Last reverse exchanges, and permits a number of non-arms’ length agreements to exist between the EAT and the Taxpayer. The parked property is treated as if the EAT is the owner for federal income tax purposes.

Relinquished Property

Refers to the property that the Taxpayer is disposing of in the exchange.

Replacement Property

Refers to the property that the Taxpayer is acquiring to replace the Relinquished Property.

Qualified Use Property

Only Relinquished Property held for investment or held for productive use in a trade or business is eligible for a Section 1031 exchange. The Replacement Property must also be held for investment or productive use in a trade or business. Property specifically excluded from Section 1031 includes: (1) inventory; (2) stocks, bonds, notes, and securities; and (3) partnership interests. Personal use property, such as vacation homes, is generally not eligible for Section 1031.

Like-Kind Property

Real Estate: Generally, any fee simple interest in real estate is like-kind to another fee simple interest in real estate. A leasehold interest in real estate with a term of thirty or more years (including options) is like-kind to a fee simple interest. The term “like-kind” refers to the nature or character of the property, not its grade or quality. The property’s use is not relevant, so for example, unimproved land can be exchanged for a multi-family building. Interests other than fee interests, such as leaseholds of less than 30 years, easements, and transferable development rights raise interesting like-kind issues often requiring analysis of state real property law.

Personal Property: The like-kind standard for personal property is narrower than for real estate. Personal property is like-kind when it is “like-class” within the meaning of Treas. Reg. §1.1031(a)-2, or like-kind within the general like-kind standard. “Like-class” is a safe harbor met when the Relinquished and Replacement Properties are within the same General Asset Class or, if not within any General Asset Class, like-class by being within the same Product Class under Division D of the Standard Industrial Classification Manual. If property is not “like-class,” no inference is made that it is not like-kind under the general standard (i.e., character or nature).

Identification Period

The Identification Period (ID Period) begins on the day that the Relinquished Property is sold and ends on midnight of the 45 th day thereafter (irrespective of whether the 45 th day is a Saturday, Sunday, or legal holiday), counting the day after the sale as Day 1. During the ID Period, the Taxpayer must identify a limited number of Replacement Properties in writing to the QI. Properties may be identified as alternative or multiple properties. There are two general rules that are used: (a) the “three property rule”; and (b) the “200% rule.” Particular care must be given to the adequacy of the description of the Replacement Property. Issues often arise in describing property under construction and in acquiring undivided interests as Replacement Property.

Exchange Period

A Taxpayer must commence and complete its exchange within the Exchange Period. The Exchange Period begins on the day the Relinquished Property is sold and ends on midnight of the 180 th day thereafter (irrespective of whether the 180 th day is a Saturday, Sunday, or legal holiday), counting the day after the sale as Day 1. If the Taxpayer’s tax return (for the taxable year the Relinquished Property is sold) becomes due before the 180 th day, the Exchange Period will be LESS THAN 180 days, unless Taxpayer obtains an extension to file its tax return. A calendar year Taxpayer with an April 15 return due date, commencing an exchange after October 17 will have its Exchange Period shortened unless it files for an extension.

Constructive Receipt

If the Taxpayer actually or constructively receives the proceeds from the sale of the Relinquished Property during the Exchange Period, the transaction will be a taxable sale and not a tax-deferred exchange, even if the Taxpayer ultimately receives property from the QI. A Taxpayer can receive proceeds at the time of sale from a party to the transaction other than the QI, such as the buyer or the title company, and the proceeds will be taxable boot. However, actual or constructive receipt from the proceeds held by the QI causes the transaction to become taxable. Generally, there are only three circumstances in which the exchange proceeds can be released to the Taxpayer: (1) at the end of the 45-day ID period if there is no additional identified property the Taxpayer has not already acquired; (2) at the end of the Exchange Period; or (3) after the end of the ID period, but before the end of the Exchange Period, if the Taxpayer has acquired all of the Replacement Property it is entitled to receive under the Exchange Agreement. Otherwise, the exchange proceeds can be used by the QI at the Taxpayer’s direction to acquire identified Replacement Property and pay certain transactional expenses.