"1031 Exchange Into a Home Your Client Plans to Live In: What Does the Mortgage Certify at Closing?"

The money from your client's sale is with the qualified intermediary, and the 45-day clock started the day the old property transferred. Three addresses are on the written identification list. One of them is a home near the water that your client has talked about retiring to for years. The loan application goes in next week, and one of its questions asks how your client will use the property.

On day one, a loan on a 1031 replacement property your client plans to live in someday is closed as an investment property, because it will be rented out at the start. The IRS safe harbor in Rev. Proc. 2008-16, a set of facts the IRS has said it will not challenge, describes 24 months of ownership with fair-rental use in each 12-month period, and the loan file describes the property the same way as a rental.

Certifying the home as a principal residence at closing would say the opposite of what the exchange says, on the same property, in the same month. This article puts both timetables on one page.

I'm Jeff Moran, a mortgage broker in Bluffton, South Carolina, originating since 1996, NMLS #483943, through C2 Financial Corporation, licensed in fifteen states. I wrote this for the CPA, qualified intermediary, real estate agent or attorney looking it up for a client. I am not a tax advisor, so every tax question below goes back to your client's CPA. My part is what the financing certifies.

The IRS safe harbor for a replacement home with personal use

Rev. Proc. 2008-16, the IRS's own text, was published in Internal Revenue Bulletin 2008-10 and applies to exchanges on or after March 10, 2008. It covers a dwelling unit that is rented to others and also used now and then by the owner. If the unit meets the procedure's qualifying use standards, the IRS will not challenge whether it was held for investment for Section 1031 purposes.

For a replacement property, section 4.02(2) of the procedure sets three tests, read here from the IRS document itself:

Rev. Proc. 2008-16 test for a replacement property	What it asks for
Ownership	Your client owns the dwelling unit for at least 24 months immediately after the exchange
Rental, in each 12-month period	In each of the two 12-month periods in those 24 months, the unit is rented to another person at a fair rental for 14 days or more
Personal use, in each 12-month period	Personal use does not exceed the greater of 14 days or 10 percent of the days in that period the unit is rented at a fair rental

A matching set of tests applies to the property your client gives up, measured over the 24 months before the exchange. Whether a rent is fair depends on all the facts and circumstances. Personal use days are counted the way the tax code defines them, which is a conversation for the CPA.

Section 4.05 says that if your client reports the exchange expecting the replacement property to meet these standards, and it later does not, your client should, if necessary, file an amended return. That return would no longer report the transaction as a 1031 exchange.

The IRS document is specific, and it is also narrow. It is a safe harbor, a set of facts the IRS has said it will not challenge, and the procedure says your client still has to meet every other requirement of Section 1031. Whether a plan that falls outside the safe harbor still works is a question for your client's CPA.

IRS Publication 523 also says a main home isn't available for a like-kind exchange in the first place. It adds that a home acquired in a like-kind exchange has its own five-year rule before the home-sale exclusion can apply, and both points belong with the CPA.

Owner-occupied, second home or investment property on the loan application

The loan application asks how your client will use the property, and the lender underwrites, prices and documents the loan around that answer. Fannie Mae's Selling Guide B2-1.1-01, Occupancy Types, recognizes three kinds: a principal residence, a second home, and an investment property. The guide defines an investment property as one the owner holds but does not live in.

Freddie Mac draws the same line from the other side. Freddie Mac Guide Section 4201.11 treats a loan as secured by a primary residence when at least one owner on the loan lives there as their primary residence. That has to be true as of the date the loan is delivered to Freddie Mac. A home your client will rent out for the next two years does not fit that description, and the loan should not say that it does.

The government programs are built for homes the client lives in. HUD Handbook 4000.1, section II.A.1.b says investment properties are not eligible for FHA insurance, apart from a few narrow exceptions such as HUD-approved nonprofits and government agencies. VA's Pamphlet 26-7, Chapter 3, Topic 5 says the veteran certifies an intent to personally occupy the home, generally within 60 days of closing. Neither fits a replacement property your client plans to rent first.

The two timetables, side by side

The table below follows the same property through the exchange and through the loan file.

Point in time	Rev. Proc. 2008-16 safe harbor	The mortgage file
Closing on the replacement property	The 24-month ownership period starts	Occupancy is certified as an investment property
First 12 months	Rented at a fair rental 14 days or more; personal use within the greater of 14 days or 10 percent of rented days	Investment property loan; the payment on your client's current home still counts when the lender compares monthly payments with monthly income
Second 12 months	The same two tests again	Nothing changes on the loan
After the 24 months	The safe harbor's ownership test is met; any move-in timing is the CPA's call	A refinance after the move, if your client wants one, would certify occupancy as it is on that day

The order of operations: investment property first, moving in later

An occupancy statement on a loan application has to be true on the day your client signs it. If your client certifies a principal residence at closing and then reports the same property as exchange replacement property held for investment, two documents now describe one property in opposite ways. Each is signed, and each goes to a party who relies on it.

Financing as an investment property first and moving in later means the loan and the tax return describe the property the same way, because on day one your client is holding it to rent out. If your client later moves in, that move is a new fact, and any financing done after it can describe it accurately. Second home or investment property covers why occupancy carries so much weight in a mortgage file.

Can a 1031 replacement property be financed as a second home?

Under Fannie Mae's and Freddie Mac's guides, it is a difficult fit with the safe harbor. Freddie Mac's Section 4201.12 requires a second home to be available primarily, meaning more than half of the calendar year, for your client's personal use and enjoyment. The safe harbor caps personal use at the greater of 14 days or 10 percent of the days rented. A home meant mainly for your client's own use and a home your client may barely use pull in opposite directions.

Fannie Mae's B2-1.1-01 says a second home must not be rental property. A footnote allows a second home where the lender finds rental income, as long as that income is not used to qualify. The home must also be under your client's exclusive control and not subject to an agreement that gives a management company control over occupancy. Investment property is the occupancy that lines up with the exchange. If a CPA has a reason to look at it differently, I'm glad to go through it on a call.

Investment property rules that touch an exchange

The financing side has a few rules worth knowing before the property goes under contract.

The exchange money can be the down payment. Fannie Mae's B3-4.3-10, Anticipated Sales Proceeds says assets for the down payment from a like-kind exchange are eligible if properly documented and in compliance with Internal Revenue Code Section 1031. Freddie Mac's Section 5501.3 lists proceeds from a 1031 exchange as eligible and documents them with the settlement or closing statement from the sale. How underwriters trace the money in your accounts covers the paper trail for the rest of the funds.

Rental income can help, with history behind it. Fannie Mae's B3-3.8-01 lets the lender use positive rental income only when your client has at least 12 months of property management experience. A client who has owned and rented the property they just sold often shows that on Schedule E of their tax return. Whether rental income counts for a mortgage walks through how it is calculated, and rent from a property bought within 45 days covers the timing when two closings are close together.

Reserves are part of the file. Reserves are the money your client still has available after closing, counted in months of the new loan's payment. Fannie Mae's B3-4.1-01 says Desktop Underwriter, Fannie Mae's automated underwriting system, looks for six months of reserves on an investment property transaction. It looks for more when your client owns other financed properties. What counts as mortgage reserves explains which accounts qualify.

The payment on your client's current home still counts. Freddie Mac's Section 4201.13 uses the housing expense on your client's current primary residence in the housing ratio for an investment property loan. That ratio is where the lender compares the monthly housing payment with monthly income. Both payments count until your client's situation changes.

Lining it up, in order

1. The CPA confirms the hold plan. Before the identification list is final, the CPA and your client settle how long the property will be rented and when a move might make sense.
2. A call with me before the property goes under contract. I can tell you how the file will read as an investment property, and whether the exchange money, the rental history and the reserves line up.
3. The application states investment property. That is the occupancy that matches the first two years of the plan.
4. The paperwork from the sale. When your client is ready, please have them provide the complete settlement statement or closing disclosure from the sale of the property they gave up, all pages, please. The lender may also ask for the exchange paperwork the qualified intermediary holds, so the funds can be traced.
5. The tax returns. Please have your client provide their complete income tax returns for the past two years, all pages and schedules, please, including Schedule E.

Common mistakes on exchange replacement financing

Checking the owner-occupied box because that is the long-term plan. The application asks about the use your client intends now, and an intent to live there in two years is a different answer.

Assuming the safe harbor's clock and the loan's clock are the same thing. The safe harbor keeps counting ownership and rental days for two years after the exchange, while the loan certifies occupancy only once, at closing.

Waiting until the 45-day list is final to talk to a lender. By then, a property that doesn't fit the reserve or rental income rules may already be on the list.

An illustration, so the calendar is visible

Numbers below are made up to show the mechanism. They are not anyone's file.

Say your client closes on the replacement property and rents it at a fair rental for 300 days in the first 12 months. Ten percent of 300 is 30, which is greater than 14, so the safe harbor's personal use limit for that period is 30 days.

  FIRST 12 MONTHS AFTER THE EXCHANGE
  ------------------------------------------
  Days rented at a fair rental           300
  Ten percent of rented days              30
  Floor in the safe harbor                14
  Personal use limit (the greater)        30
  Personal use days, in this example      21
                                      ------
  Within the limit                       Yes

  THE MORTGAGE FILE, SAME PERIOD
  ------------------------------------------
  Occupancy certified at closing  Investment
  Change needed on the loan             None

In this example, 21 days of personal use fall inside the limit. If the second 12 months come out the same way, both documents agree for the full two years.

Talking it through before the contract

If a client of yours is exchanging into a home they hope to live in someday, you are welcome to call me at (843) 765-0000 before the replacement property goes under contract. I'll go through how the loan will read and what to have ready, so the tax side can be settled with the financing already mapped. Purchase, refinance and cash-out explained covers the loan types if a refinance after a future move is part of the plan.

Nothing here is tax advice, legal advice or a credit decision; the decision on any file is the lender's.

Common questions

Can you live in a 1031 exchange replacement property?

Your client can move in later, and the timing is a tax question for their CPA. The IRS safe harbor in Rev. Proc. 2008-16 describes 24 months of ownership after the exchange, with at least 14 days of fair-rental use in each 12-month period and limited personal use. On the loan, a property your client will rent first is financed as an investment property.

Can I get an owner-occupied mortgage on a 1031 replacement property?

Owner-occupied financing is for a home your client lives in. Freddie Mac treats a loan as secured by a primary residence when an owner on the loan lives there as their primary residence when the loan is delivered. A replacement property held for investment under a 1031 exchange is financed as an investment property at closing.

What is the Rev. Proc. 2008-16 safe harbor for replacement property?

The IRS says it will not challenge whether a dwelling unit was held for investment if your client owns it for 24 months after the exchange. In each of the two 12-month periods, the unit has to be rented at a fair rental for 14 days or more. Personal use in each period must not exceed the greater of 14 days or 10 percent of the days rented at a fair rental.

Can 1031 exchange funds be used as a down payment on a mortgage?

Yes. Fannie Mae's Selling Guide B3-4.3-10 says down payment assets from a like-kind exchange are eligible if properly documented and in compliance with Section 1031. Freddie Mac's Section 5501.3 lists proceeds from a 1031 exchange as eligible, documented with the settlement statement from the sale.

Can a 1031 replacement property be a second home on the mortgage?

It is a hard fit. Freddie Mac requires a second home to be available more than half the calendar year for personal use, while the safe harbor keeps personal use small. Fannie Mae says a second home must not be rental property, though rental income can be present if it is not used to qualify.