The 1031 Exchange is one of the most tax-friendly tools available to real estate investors. But using it successfully requires meeting strict deadlines set by the IRS. In markets where inventory is tight, like the Mountain West, traditional bank funding is too slow to keep up with the pace of the 1031 Exchange. So private money is preferred.
Private money, structured as a hard money or bridge loan, is a strategic bridge capable of keeping a 1031 deal alive and well. When all deadlines are met and the targeted properties change hands, an investor avoids having to pay a massive tax bill.
Why Private Money Is So Important
Private money is critical for real estate investors looking at 1031 Exchanges for one specific reason: they only have 45 days to identify replacement property. They only have 180 days to close on it. If an investor’s bank needs 60 days just to complete the underwriting process, getting things done on time is not likely.
How the 1031 Exchange Works
A 1031 Exchange is a scenario in which a real estate investor sells one property and replaces it with a similar property. As long as things are done according to the rules, the investor can avoid paying tax on the sale. That tax is deferred until the new property is sold.
The deal’s name comes from the fact that the investor is simply exchanging one property for another. He might sell a multi-family residential property and use the money to buy a comparable property on the other side of town.
As previously mentioned, a real estate investor only has so much time to get both deals done. This is sometimes harder said than done because an investor does not know what he will get for the property he is selling until he starts seeing offers. That makes it harder to look for replacement properties ahead of time.
Three Key Advantages of Private Money
While it is not impossible to use bank funding on a 1031 Exchange deal, doing so is quite difficult. Private money offers three key advantages traditional lenders simply cannot touch:
- Closing Speed – Private lenders can typically get from approval to closing in 5-10 days. Imagine an investor already approaching day 170. With just 10 days to go, he needs fast funding.
- Asset-Based Underwriting – Because private money is offered by way of asset-based underwriting, lenders are not afraid of distressed or high-vacancy properties. They are willing to fund investments that banks will not go near.
- Early Repayment – Although there are exceptions to the rule, most hard money and bridge loans do not come with early repayment penalties. That is ideal for an investor who only needs private money to complete the acquisition.
Actium Partners, a Utah hard money lender based in Salt Lake City, says that hard money and bridge loans are short-term instruments by design. Average terms are 6-12 months. Some lenders will go as long as 24 months should circumstances dictate, but anything beyond that is extremely rare.
The Reverse 1031 Exchange
Something else private money can do for the real estate investor is to facilitate a Reverse 1031 Exchange. This is a scenario in which the investor uses hard money to purchase a replacement property first, then turns around and sells another property in his portfolio. A qualified intermediary holds title to the purchased property until the portfolio property is actually sold.
Whether an investor is looking at a traditional or Reverse 1031 Exchange, private money is the best way to fund property acquisition. Traditional lenders simply cannot compete when it comes to 1031 Exchange deals.
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