Can I draw from an existing HELOC before I sell? And a separate question about a lien

Question

Hi,

I have a lease ending on a rental property, and it's time to sell and buy in another location.

The property has a mortgage, a HELOC, and also a 3rd lien where remaining equity was used as collateral for an unrelated loan.

The 3rd lien will need to either attach to the new rental or get moved to my primary residence as substitute collateral.

First question: the HELOC. In order to move the lien to my primary residence, I would need to reduce the equity in the property I'm selling and/or increase the equity in my home (which also has a HELOC). The rental HELOC originated years ago. The only way to do this would be to draw from the rental HELOC and use that to pay down the primary residence HELOC. For the purposes of doing a 1031, is it sufficient that the rental HELOC was in existence already? Or would anything I draw from it now be considered boot?

Second question: 1031 and the lien. The 3rd lien-holder is ok to move the lien and collateral to a new rental property, but only if

1) Proceeds will be held in an interest-bearing account pledge as collateral to the loan and/or
2) Proceeds can be used to pay principal down on your loan.
3) Proceeds can be used to purchase another property similar in nature that is the same or greater than the amount of equity in the existing property— (new property will replace existing as collateral on your loan).

I'm asking them for clarification for case 3 to see if it would be acceptable for the QI to hold those proceeds. But if I were the bank I would assume not. If the bank wants to hold the funds in the interim, I assume that means there's no way to 1031. Is there any way around this?

If they are ok with the QI holding the funds but need me to promise the funds to them if I don't buy something new (or some sort of similar promise), would that count as me having that money and prohibit a 1031?

This is my first time through this and I'm just getting started, so I don't have any advisors yet and I'm just trying to make sure this can all work before I start the ball rolling.

Thanks!

I'm asking them for clarification for case 3 to see if it would be acceptable for the QI to hold those proceeds. But if I were the bank I would assume not. If the bank wants to hold the funds in the interim, I assume that means there's no way to 1031. Is there any way around this?

If they are ok with the QI holding the funds but need me to promise the funds to them if I don't buy something new (or some sort of similar promise), would that count as me having that money and prohibit a 1031?

This is my first time through this and I'm just getting started, so I don't have any advisors yet and I'm just trying to make sure this can all work before I start the ball rolling.

Thanks!

Benjamin D. · Answer

Hi @davefoster1031, thanks for the info/thoughts!

To clarify, the 3rd lien is not technically owed any of this money or proceeds unless I default on my unrelated business loan. They weren't offering to act as a QI or facilitate the exchange, those were their conditions for allowing me to move the lien/collateral to another property (which they have no obligation to do). I think the "interest bearing" bit just meant that they would hold the cash in my name while it's between sales, not that they'd be doing anything with it. They just don't want to let it out of their control after they've released the lien until they have a lien on another property.

On #3, I would think so, but they so far have pushed back on that, as they technically wouldn't have a legal right to that money until the second closing. I do wonder if they'd be satisfied with a side contract promising to pay them back if the 1031 sale does not go through for some reason, or if their collateral does not get replaced within 180 days, or whatever. I didn't get the sense they would go for it. I'm also curious if that obligation would run afoul of the 1031 rules.

On #4, there's nothing that needs to be paid back to the 3rd lien, they just want to have at least as much collateral on the new property as they do on the relinquished property.

I'm not looking to cash anything out (either before or after the sale), I really just want to swap properties and am just trying to figure out the best way to handle it with this pesky extra lien.

One question for you: for answering your #1, which professional (with 1031 experience) is most qualified to answer that or help me decide how to structure the movement of funds: a QI, a lawyer, an accountant, or someone else?Thanks!

Dave Foster · Answer

@Benjamin D., Everyone of those folks will have an opinion - and probably none of them will have a definitive answer because there is so little case law surrounding this compared to the number of exchanges.  And it is up to quite a bit of interpretation as well as being incredibly transparent optically.

Probably your accountant would be best.  But only because they understand the overall situation for you.  And what if any audit risk exists outside the 1031.  Accessing that heloc will never trigger an audit.  And like you said, the only way to sell the property is to create that new debt structure.

Dylan Speer · Answer

• Regarding the HELOC, the fact that it originated years ago may be sufficient to qualify it for the 1031 exchange, but this will ultimately depend on the specifics of your situation and the advice of a qualified tax professional. 
• However, drawing from the rental property HELOC and using those funds to pay down the primary residence HELOC could potentially create boot and affect the eligibility of the 1031 exchange. It's important to consult with a qualified tax professional to assess the specific details of your situation and determine the best course of action.
• 
• With regards to the 3rd lien, it sounds like the lender is open to allowing the lien to be moved to a new rental property as long as the proceeds are held in an interest-bearing account, used to pay down the loan, or used to purchase a similar property. If the lender is open to having the QI hold the funds and you make a promise to use them in accordance with the lender's requirements, this could potentially still qualify for the 1031 exchange. However, it's important to confirm with a qualified tax professional and ensure that all requirements are met. Feel free to reach out. Happy to chat. 
•

Dave Foster · Answer

@Benjamin D., Interesting situation with a lot of moving parts.

1. Accessing a heloc right before a sale might (or might not) be seen as taking boot.  We've seen exchanges fail when the IRS interpreted that the new debt right. before a sale and 1031 was done simply to free up cash (profit) from the sale.  Conversely, other exchanges have passed when the purpose of accessing cash was their normal business operation done at a usual time under usual circumstances.  In your case it sounds like you could make the case you're not benefiting from it.  and it has to be done to make your sale work.

2. Just my two cents but any QI for a 1031 exchange who is paying or making interest on your account is really in the business of investing your money not doing your exchange.

3. If all the funds go into a 1031 account and are used to purchase a new property that seems like that would satisfy your 3rd lien holder.

4. All of the net proceeds from the sale have to go to the purchase of the new property.  The QI can't hold extra proceeds.  And you can't touch them.  If you're looking for a patial payoff of the 3rd lien then that would simply need to be on the settlement statemet of the sale.

Benjamin D. · Answer

@jaronw2 and @hunterr69

The HELOC on the rental is completely paid off but still open.

The unrelated loan is for a business which is doing fine, so I'm not worried. But I'm not able to get rid of it yet.

Do either of you know if drawing from an existing HELOC would be considered boot?

Or if the lien-holder needing to hold those funds precludes a 1031?

Hunter Reed · Answer

Ben, why do you have so many liens and helocs? Look to pay the helocs off first.

Jaron Walling · Answer

@Benjamin D. Are you not concerned about the number of loans on these properties? "Collateral for an unrelated loan" - that sounds fun.

Can I draw from an existing HELOC before I sell? And a separate question about a lien

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