Prepayment Penalties and Defeasance in a 1031 Exchange

If the loan on the property you are selling carries a prepayment penalty, yield maintenance or a defeasance requirement, paying it off at closing is part of your 1031 exchange whether you plan for it or not. The cost comes out of the sale proceeds, so less equity reaches your Qualified Intermediary. Defeasance can also take weeks to arrange, which moves your closing date and therefore the start of your 45 and 180 day periods. How the payment itself is treated for tax purposes is not fully settled, so it is a question for your CPA before you sign a contract.

What kinds of prepayment cost show up on a commercial loan?

Most residential mortgages can be paid off at any time without a fee. Many commercial and investment property loans cannot. The three structures owners run into most often are these.

• ›Step down penalty. A fixed percentage of the balance that falls over time, for example 5 percent in year one, 4 percent in year two and so on until it reaches zero.
• ›Yield maintenance. A formula that compensates the lender for the interest it loses when you repay early. It is usually tied to Treasury yields, so the cost can rise when rates fall.
• ›Defeasance. Common on loans that were packaged into commercial mortgage backed securities. You do not repay the loan. Instead you buy a portfolio of government securities that replaces the property as collateral, and the lien on your property is released.

The prepayment section of your note says which applies.

How does defeasance affect the 1031 timeline?

Defeasance is a process, not a payoff letter. The servicer typically requires advance written notice, often 30 days or more. You usually engage a defeasance consultant, a securities broker, an accountant to certify the cash flows and attorneys on both sides. A successor borrower entity is often set up to hold the securities.

All of that has to come together on the day the sale closes, because the lien must be released for the buyer to take clean title. If any piece is late, the closing moves.

That matters because your exchange period starts on the date you transfer the relinquished property. A closing that slips by two weeks pushes your identification deadline and your final deadline by two weeks as well. The practical point is to build the defeasance schedule and the purchase contract timeline together, not discover one after you go under contract.

Can the penalty be paid from exchange proceeds?

The payoff of your existing loan, including any prepayment charge the lender requires, is normally paid by the closing agent out of the sale proceeds before the remaining funds go to the Qualified Intermediary.

The open question is how the charge is characterized. There is no single IRS ruling that settles it for every situation. Some advisers view a prepayment penalty as a cost of disposing of the property, similar to a closing cost. Others view it as additional interest on the loan, which may be deductible on its own but is not a selling expense. The difference can affect whether part of the proceeds is treated as boot, and how your gain and basis are calculated.

Because of that uncertainty, some owners choose to pay a prepayment penalty with outside cash rather than exchange funds. Others are comfortable with the closing agent paying it from proceeds. This is exactly the kind of decision your CPA should make, in writing, before closing, and your Qualified Intermediary can tell you how it typically handles these line items on a settlement statement.

Defeasance has its own wrinkle. The money used to buy the replacement securities is far larger than a typical penalty, and the transaction is technically a substitution of collateral rather than a payoff. Your CPA will want to see the defeasance closing statement alongside the sale settlement statement.

What does this do to the equity you reinvest?

Illustrative example only. These figures are invented to show the arithmetic, ignore most closing costs, and do not describe any real loan, property or outcome.

Suppose an owner sells a property for 2,000,000 dollars. The loan balance is 1,000,000 dollars and the note carries a 2 percent step down penalty in the current year. Other closing costs are 60,000 dollars.

• ›Prepayment penalty: 2 percent of 1,000,000, which is 20,000 dollars
• ›Loan payoff including penalty: 1,020,000 dollars
• ›Cash reaching the Qualified Intermediary: 2,000,000 less 1,020,000 less 60,000, which is 920,000 dollars

Without the penalty, 940,000 dollars would have reached the Qualified Intermediary. The 20,000 dollars is gone from the equity available for the next purchase, and depending on how your CPA treats it, it may also affect how much boot, if any, the exchange produces.

Yield maintenance or defeasance on the same balance can cost far more than 2 percent when rates have fallen since the loan was made.

How does it interact with replacing the debt?

To defer all of the gain, owners generally need to buy replacement property of equal or greater value and reinvest all of the net equity. Debt that is paid off on the sale side generally needs to be matched by new debt or added cash on the purchase side.

The loan balance you pay off is the figure your CPA will look at for debt relief. A prepayment charge is not part of that principal balance, but it does reduce the cash you can put toward the replacement property. If you were counting on the full equity to make a down payment work, a penalty or defeasance cost can leave a gap you have to fill with outside cash or a larger new loan.

Are there ways to avoid the cost altogether?

Sometimes. A few approaches come up often, each with its own tradeoffs.

• ›Wait for a step down. If the penalty drops at the next loan anniversary, timing the closing just after that date can reduce the cost. This only works if the buyer and the market cooperate.
• ›Loan assumption. Some loans allow a qualified buyer to assume them. The penalty may be avoided, but the lender has to approve the buyer and charges its own fees, and you are relieved of the debt for exchange purposes just as if you had paid it off.
• ›Negotiate with the lender. Some portfolio lenders will reduce or waive a penalty, particularly if you plan to finance the replacement property with them.

What should you gather before listing?

Pull the note and any loan agreement, find the prepayment section, and ask the servicer for a current payoff estimate including the charge. If defeasance applies, ask how much notice the servicer requires and who it expects you to use. Then share all of it with your CPA and your Qualified Intermediary before you agree to a closing date.

A prepayment charge is one of the few exchange costs that is written down years before you sell. Reading it early gives you time to plan the sale, the timeline and the replacement purchase around it, rather than finding it on the settlement statement the week of closing.