Reverse Exchanges Growing in Popularity
Preserve Ability to Defer Gain without a Buyer
How times have changed in the last twelve months. We have watched the real estate market make an about face and is now a seller’s market. This is causing buyers to act fast once they find the property they want and they are up against other potential buyers offering more than the asking price and willing to close soon. Putting a contingency that your old property must close first is not as easy now as it was just a few months ago.
This has helped increase the use of reverse exchanges over the last twelve months as exchangers strive to get their desired property while preserving their ability to defer the gain.
What Is A Reverse Exchange?
A reverse 1031 exchange is a strategy used when you want to defer the capital gain under Section 1031 but must acquire the replacement property prior to conveying title of your relinquished property to a buyer. The most common situations that necessitate a reverse exchange include:
- You must settle on the replacement property or lose substantial down monies.
- Contingencies on the sale of the relinquished property have not been removed prior to the closing of the replacement property.
- A Buyer for the relinquished property has not been found and the closing on the replacement property cannot be postponed without jeopardizing the transaction.
- Favorable financing commitments will expire without the immediate acquisition of the replacement property.
- You wish to make improvements to the replacement property, which cannot be completed within the 180-Day Exchange Period.
A 1031 exchange is considered to be a continuation of the initial investment and cannot be accomplished if you simply own both properties. It must contain the sale of relinquished property followed by the purchase of replacement property within 180 days.
Overview of Reverse Exchanges
Revenue Procedure 2000-37 provides a “safe harbor” for reverse exchanges. A “safe harbor” generally means the IRS will not attack a transaction if it is structured within the rules specified. The Rec. Proc. uses a structure called a Qualified Exchange Accommodation Arrangement (QEAA). To facilitate the reverse exchange, legal title to either the relinquished or the replacement property must be held by an Exchange Accommodation Titleholder (EAT) until title to the relinquished property can be conveyed to a buyer. The EAT is typically a single member limited liability company in which the single member is the Qualified Intermediary (QI) or an affiliate of the QI. The safe harbor allows the EAT to “park” legal title for a maximum of 180 days with all of the burdens and benefits of ownership including maintenance of accounting records and tax reporting. To protect your property, the entity used to hold title to your property should only ever hold title to this one property and should be dissolved immediately after title is conveyed from the EAT.
How Does A Reverse Exchange Work?
Financing and the anticipated length of time the EAT is expected to "park" title to your property are usually the determining factors when deciding whether the EAT takes title to your replacement or relinquished property.
Parking the replacement property (an “Exchange Last”) is generally preferred when you have existing debt on the relinquished property that cannot be paid off or if you wish to complete improvements to the replacement property during the 180-day QEAA period.
These are the steps to setting up an Exchange Last reverse:
- You enter into an Exchange Agreement with a Qualified Intermediary (QI) and a Qualified Exchange Accommodation Agreement (QEAA) with an Exchange Accommodation Titleholder (EAT).
- The EAT executes the Agreement of Sale for the replacement property as buyer. If you have already signed the Agreement, the agreement and the deposit can be assigned to the EAT.
- Using funds loaned to the EAT either by you and/or a third party lender, the EAT acquires the replacement property directly from the seller.
- The EAT “parks” the property until the relinquished property is conveyed to a buyer which must be completed within 180 days.
- You enter into a $1 triple net lease agreement with the EAT which requires you to maintain the property, pay all insurance, real estate taxes and utilities. You can also sublet the property to a tenant and claim all of the income and expenses associated with the property (excluding depreciation during the QEAA).
- By midnight of the 45th day after the EAT acquires the replacement property, you must identify property you intend to sell in the exchange.
- Once title of your relinquished property is conveyed to a Buyer and before the end of the 180-Day Exchange Period, the EAT conveys title of the replacement property to you and any note and mortgage executed by the EAT is satisfied.
Parking the relinquished property (an “Exchange First”) may be a better option for you when there is no debt on the relinquished property or the existing debt can be paid off or assigned to the EAT; the existing lender has agreed not to call the loan when title of the relinquished property is transferred to the EAT; the replacement property is located in a state that would require payment of duplicate transfer taxes of a larger amount than the relinquished property or there is complex financing already in place on the replacement property.
To structure an Exchange First reverse exchange, you must enter into an Exchange Agreement with a QI and a QEAA with the EAT as in an Exchange Last reverse.
However in order for the EAT to acquire the relinquished property, you will need to follow these additional steps:
- The EAT buys the relinquished property from you using money you must loan to the EAT.
- You enter into a triple net lease with the EAT.
- When you secure a Buyer, the EAT enters into an Agreement of Sale to sell the relinquished property to the Buyer and title to the relinquished property is conveyed directly from the EAT to the Buyer.
- You have 180 days to complete the reverse exchange by having the EAT convey title of the relinquished property to a Buyer.
Things to Keep in Mind
- The equity in the replacement property must be equal or greater than the equity in the relinquished property and the value must be greater.
- In an Exchange First if you sell the relinquished property for more than you sold the property to the EAT, you may have taxable boot on the difference. If you sell the property for less there will be no boot and the Mortgage from the EAT will be satisfied when title is passed to the Buyer.
- Any money loaned to the EAT is secured through a promissory note or mortgage.
- You are not entitled to depreciation while the EAT is in title to the property.
While there are additional costs and they require more planning, if you have identified the property you want to acquire but have not yet secured a buyer and need to close soon, consider a reverse exchange. A reverse 1031 exchange is more complex than a regular 1031 exchange but provides the opportunity to make what seems like an impossible situation, possible.