A 1031 exchange gone wrong

Q: During the process of completing a 1031 exchange, my mortgage broker told us the day before our 180 day limit for closing on our purchase that our lender didn't approve the development.

We worked with this broker for six months, got approved and even went to the title company and signed forms. Can I sue the mortgage company for negligence? Their refusal to approve this property cost me $42,000 in taxes.

I wanted move into this property in the next couple of years and probably wouldn't have had to pay this much in taxes. What kind of attorney should I talk to?

A: We're unsure from the details you describe whether you would have any remedy against the mortgage lender. It seems to us that you were using a residential mortgage lender for your investment real estate purchase.

Let's take a step back. A 1031 exchange refers to a section of the Internal Revenue Code that permits the deferral of federal income taxes when you sell a piece of investment real estate (or another investment property) and buy a like-kind replacement. If you own an investment piece of real estate, you can sell that property and buy a different investment property without having to worry about paying federal income taxes on the sale of the first property.

But the rules regulating a like-kind exchange of properties are rather strict. Once you sell the existing property, you can buy a replacement property for the same or greater value. But, you must "designate" the replacement property within 45 days of the sale of the old property and you must close no later than 180 days (or in some cases, depending on when you file your federal income taxes, the time period might be shorter) following the closing of the sale of the old property.

Through this entire process, you generally must use a qualified intermediary for the sale and purchase of the properties.

Property owners frequently think that they can set up a 1031 exchange after they have sold their existing property. They can't. You must plan ahead and set up the like-kind exchange at or prior to the closing. Usually, you should think about the exchange when you are planning to sell the property and have the company that will act as the qualified intermediary on hold pending the sale.

At the sale of the old property, you receive no cash from the sale. All of the proceeds from the sale must go to the qualified intermediary for use in the purchase of the new property.

If you followed these rules, you had exactly 180 days from the sale of your old property to close on the purchase of your replacement property. But, you didn't. The unfortunate news is the IRS doesn't care why you didn't or couldn't close on the replacement property. If you fail to close, you have to pay taxes on the sale of the old property. You might have capital gains taxes and the recapture of depreciation to pay the IRS for the failed 1031 exchange.

As with other real estate deals, it is up to you to make sure you get your financing lined up. You knew you had 180 days to close on this purchase. Your lender probably has no greater duty to close your deal with or without the tax-deferred exchange you were expecting.

Six months is quite a long time to work with a lender. You probably should have tried to close on this deal a couple of months earlier or found a different lender to close your transaction. Knowing the amount of money you had on the line, you should have had a backup plan in case you didn't get the financing lined up.

Having said all that, your letter does not describe any negligence on the part of the lender. You only describe how they took so long and then found out the development wasn't approved by the end lender. Since we're guessing you used a residential lender, we're wondering whether you applied for this loan claiming that the home would be your primary residence. If so, your declaration that the home wouldn't be for investment purposes would defeat a 1031 exchange. You must under all circumstances treat the replacement property as a purchase for investment purposes and not for your own use.

If you were working with a commercial lender, we're baffled why the commercial lender didn't close the loan earlier or decline the applications months earlier. These days, residential lenders are a finicky bunch and the whole process seems tedious and frustrating. Unless you have specific details of the lender's negligence, we don't know how far you will get with a claim against this lender.

You can talk to an attorney that specializes in litigation. While some experience in real estate mortgage lending might be useful, it appears that the information you seek would fall into the general aspect of whether the lender owed you a certain duty to get the loan completed, whether they failed in that duty and whether that failure rises to the level where the lender would be liable to you for damages. Now, even if the lender is liable to you for their "negligence," it's questionable whether they would be liable to you for the taxes you ended up owing to the IRS.

Please tell us how things end up.

(Ilyce R. Glink is the author of many books on real estate and host of "Real Estate Minute" on her YouTube.com/expertrealestatetips channel. Samuel J. Tamkin is a Chicago-based real estate attorney. If you have questions, you can call her radio show toll-free (800-972-8255) any Sunday, from 11a-1p EST. Contact Ilyce through her Web site, http://www.thinkglink.com.)

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Sun archive: Dream Home

Dream Home takes readers into the houses of Baltimore area residents who have found their ideal home

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