Do you pay a prepayment penalty when you sell for a 1031 exchange?

Hans Goldstein structures installment sales for sellers and works alongside their CPAs and brokers. Email hans@goldsteinco.net or call 213-414-2808.

Why doesn't the 1031 exchange avoid the penalty?

Because the exchange is a tax rule and the penalty is a contract term. Your lender is not a party to the exchange. When the property sells, the due-on-sale clause makes the loan payable, and the Garn-St Germain Act makes that clause enforceable. Its exceptions are for residential situations, so they don't help a commercial seller. The lender is paid off from the sale proceeds at closing, and the prepayment terms in your note decide what that payoff costs.

The penalty is not the only surprise. Once the old loan is gone, the replacement property generally has to carry at least as much debt, or you add cash, to defer all of the gain. That is a new loan at today's rates. See the 1031 debt replacement rule.

What kinds of prepayment terms will you find?

Four, and your note will say which one in a paragraph usually titled "Prepayment."

Step-downs are simple to price. Yield maintenance and defeasance move with Treasury yields, and the comparison between them is its own topic: see yield maintenance vs defeasance when selling. A lockout is the hard one: during a lockout, the loan can't be paid off without the lender's consent, and a sale that requires payoff may not be possible on your timeline.

Most notes also have an open window at the end. Many step-down loans waive the penalty in the last 90 days, per Multifamily.loans, and the Freddie Mac fixed-rate term sheet states "No prepayment premium for final 90 days."

Worked example: a seven-month-old loan

Here is a rounded version of a deal on my desk: an office building selling for about $4.0M, with about $2.1M of debt taken out seven months before the sale. Seven months in is the costly spot on a step-down schedule, because the loan is still in year one, where the percent is highest.

The prepayment terms below are illustrative. The real figure is whatever the note says.

Arithmetic: $2.1M x 5% = $105,000; $2.1M x 3% = $63,000. The balance is rounded to $2.1M; if the loan amortizes, a few months of principal paydown lowers it slightly.

Now follow the money at closing, with commissions and other closing costs left out to keep it clean:

In an exchange, that equity is what reaches the qualified intermediary. If the seller still wants a $4.0M replacement, the new loan has to be bigger to fill the gap: $4.0M minus $1,795,000 = $2,205,000 under the 5% schedule. The penalty doesn't only cost $105,000 once. It also adds $105,000 to the new loan you carry, at today's rates.

Is waiting worth it? Under the 5-4-3-2-1 schedule, selling in month 13 instead of month 7 would cut the penalty from $105,000 to $84,000, a $21,000 difference. Against that, weigh six more months of ownership, the buyer you have now, and where rates and prices go. With a real buyer in hand, $21,000 is often not worth the wait. It can be when the difference is larger, or when the open window is close.

How is the penalty treated for tax?

This is a question for your CPA, and it should be settled before closing. A prepayment penalty is often treated as interest (deductible) rather than as a selling expense. That matters in an exchange: paying costs that aren't transactional closing costs out of exchange funds can create taxable boot. So the seller's CPA and the qualified intermediary should agree on how the penalty is paid and reported before the settlement statement is final. This page doesn't state it as settled law, because the answer depends on your facts and your note.

What does the market look like as of October 2026?

Two things push prepayment cost up for sellers right now.

• Many loans are young. The Mortgage Bankers Association reported on Feb. 9, 2026 that $875B of commercial and multifamily mortgages, 17% of the $5.0T outstanding, mature in 2026. Loans that refinance start over on a new note, and a new note sits in the most expensive years of its prepayment schedule.
• Rates moved up, which cuts both ways. The Fed raised its target range by 0.25 point to 3.75% to 4.00% at its Sept. 16, 2026 meeting (Federal Reserve FOMC statement), and the bank prime rate was 7.00% for the week of Sept. 25 to Oct. 1, 2026 (Federal Reserve H.15). Bank loans are often priced off prime or Treasuries. A step-down penalty doesn't care about rates; it is a flat percent. Yield maintenance does: with the 10-year Treasury at 5.24% on Oct. 1, 2026 (FRED, DGS10), an older note written at a lower rate may cost only its floor, while a young note written at today's rates is the expensive case if Treasury yields fall.

What should you do before you list?

1. Pull the note and find the prepayment paragraph. Identify the type, the schedule, any lockout end date and the open window.
2. Ask the servicer for a payoff quote for your target closing date. For yield maintenance or defeasance, ask how it is calculated and how long a quote is good for.
3. Put the penalty in the net sheet. Brokers: put it there before the seller sees an offer, so it isn't found at escrow.
4. Pick the path with the penalty included. The penalty is due whether you exchange, sell outright or do a structured sale. What differs is what happens after the payoff.

Does a structured installment sale avoid the penalty?

No. A structured installment sale still pays off the old loan at closing, penalty included. The payoff is part of what you receive in year one, so it is a year-one payment, taxed at the sale's gross profit ratio. Illustration only: if your adjusted basis were $600,000 (assume the $885,000 purchase in 2019 less $285,000 of depreciation; your records set the real figure), the gross profit ratio would be ($4.0M minus $600,000) / $4.0M = 85%, so about $1,874,250 of the $2,205,000 used for payoff and penalty would be gain reported in year one. Depreciation recapture is taxed in the year of sale either way.

What it removes is the new loan. The buyer pays in full at closing, part of the price goes to an assignment company that funds your payments with a fixed annuity from an insurer, and you report the rest of the gain under IRC §453 as payments arrive. You are not the lender. The trade-offs: payments are locked once set and cannot be accelerated or cashed out, they depend on the assignment company and the insurer behind it, there is no published IRS ruling on this specific structure so your CPA should review it, a commission of about 4% of the amount structured is built into the pricing, and interest in each payment is ordinary income. It must be in the purchase agreement before closing.

Run both paths with your own numbers in the advanced calculator, or send Hans the deal and he will lay them side by side for your CPA.

Frequently asked

Q: Can the buyer assume my loan so I skip the penalty? A: Sometimes, if the note allows assumption with lender approval and a fee, which is more common on agency and CMBS loans than bank loans. You would still have debt relief to replace in a 1031. See can you assume a loan in a 1031.

Q: Can my qualified intermediary pay the prepayment penalty from exchange funds? A: It is paid at closing, but whether it should come from exchange funds is a question for your CPA and QI. Penalties are often treated as interest rather than a selling expense, and non-closing costs paid from exchange funds can create boot.

Q: What is a lockout? A: A period, common early in CMBS loans, when the loan cannot be prepaid at all. If you are in one, a sale that requires payoff may need lender consent, a defeasance, or a buyer who assumes the loan.

Q: Is it worth waiting for the step-down? A: Run the difference. On a $2.1M balance under 5-4-3-2-1, moving from year one to year two saves $21,000. That has to beat the cost and risk of holding longer.

Q: Does selling outright avoid the penalty? A: No. Any sale that pays off the loan triggers the prepayment terms. The penalty belongs to the loan, not to the tax path you choose.

What should you read or run next?

• Advanced calculator
• 1031 boot calculator
• Yield maintenance vs defeasance when selling
• Do I need a new loan for a 1031 exchange?
• Mortgage boot and 1031 exchange boot
• What is taxed in year one of a structured sale?
• For brokers

Who wrote this?