A reverse exchange can make this possible, but the taxpayer must set up the reverse exchange with Reverse 1031 CORP. before acquiring the replacement property from the seller.  If the taxpayer acquires the replacement property directly from the seller, he will own both the relinquished and replacement properties and there will be no exchange.   

While many different reasons exist as to why the purchase may need to take place before the sale, a couple examples include that the taxpayer may run the risk of losing that perfect replacement property in a competitive real estate market or the sale of the relinquished property cannot be accomplished in advance of the purchase.

The taxpayer cannot acquire the replacement property until the relinquished property is transferred to the buyer. By utilizing a “reverse exchange” under Rev. Proc. 2000-37, the IRS provides a “safe harbor” to enable the taxpayer to preserve the ability to exchange. Using an Exchange Accommodation Titleholder (EAT), the title to the replacement property is parked for up to 180 days, allowing the taxpayer to transfer the relinquished property to a buyer. Reverse 1031 CORP., acting as the EAT, creates a titleholder LLC to acquire the replacement property directly from the seller. The taxpayer and/or a third-party lender lends the EAT the funds to purchase the property and the EAT enters into a NNN lease with the taxpayer. 

To avoid the taxpayer taking title to the replacement property prior to the sale of the relinquished property, the safe harbor rules require “parking” title to the replacement property with an Exchange Accommodation Titleholder (EAT) until the relinquished property is sold as part of a regular forward exchange. A special purpose entity, referred to as a titleholder LLC, is formed by the EAT to acquire the parked property. Once the old property is sold in conjunction with 1031 CORP., acting as the Qualified Intermediary (QI), the parked property is transferred to the taxpayer. The transfer must occur within the 180-Day Exchange Period beginning when the EAT acquired the replacement property.

Yes, it is more common for the replacement property to be parked with the EAT but it is possible for the taxpayer to sell the relinquished property to the EAT first.

As part of a regular forward exchange with 1031 CORP. as QI, the taxpayer conveys the relinquished property to the EAT by deed and the taxpayer funds its own exchange account with the QI equal to the amount of equity it has in the relinquished property. Then, using the exchange funds the taxpayer provided to the QI, the replacement property is purchased as part of the forward exchange. Once the taxpayer finds a bona fide purchaser for the relinquished property, the EAT sells the old property to the new buyer. The net proceeds from the relinquished property sale are used to pay down any mortgage debt encumbering the old property with the balance to the taxpayer. The taxpayer should be mindful of transfer taxes, costs, and other expenses associated with a relinquished property transfer as part of a reverse exchange. Also, the taxpayer should confirm with any and all mortgage lenders that the potential exchange will not trigger an event of default.

Essentially the same reverse exchange procedures may also be used to acquire and construct improvements to the replacement property as part of an improvement exchange. The improvements must be completed before the taxpayer acquires the property. The replacement property may be acquired first or last using the EAT. Then, the taxpayer can begin performing work on the parked property and pay for labor, services, and materials that are incorporated and made part of the real estate during the exchange period. When the exchange funds are exhausted through the draw request and distribution process or the 180-Day Exchange Period has lapsed (whichever is earlier), the improved property is conveyed to the taxpayer by deed or assignment of the membership interest in the titleholder LLC. The enormous benefit of an improvement exchange is that the value of the property transferred to the taxpayer includes not just the initial acquisition cost but also the value of all improvements the taxpayer can complete and pay for before the transfer. It is important to note that all replacement properties and the proposed improvements described with as much specificity as reasonably practicable need to be identified within 45 days.

The taxpayer cannot acquire the replacement property directly from the seller and begin improvements. However, the transaction can be structured as a reverse improvement exchange because the purchase transaction takes place first in time. The EAT will acquire the replacement property and make the desired improvements using funds loaned to it by the taxpayer and/or a third-party lender. The subsequent sale of the relinquished property must be structured as a regular forward exchange with its own separate documentation and fee, with 1031 CORP. serving as the Qualified Intermediary (QI). The exchange proceeds from the sale of the relinquished property can be used to reimburse the taxpayer for the out-of-pocket cash it loaned to the EAT to acquire the parked property and pay for the improvements.

The last step in a reverse or improvement exchange is for the EAT to convey ownership of the replacement property to the taxpayer. The transfer of the replacement property by the EAT to the taxpayer can be accomplished by transferring the deed or assigning the membership interest in the titleholder LLC  holding title to the property.

Several financial, administrative, legal, and tax considerations exist when concluding a reverse or improvement exchange via deed transfer or an assignment of the membership interest in the titleholder LLC holding title to the property, particularly when a third-party lender is involved. As with all matters concerning 1031 exchanges, it is highly advisable to consult with an independent professional regarding the legal and tax consequences of either using a deed transfer or an assignment of membership interest in the LLC to conclude a reverse or improvement exchange transaction. Your Reverse 1031 CORP. Exchange Officer will work with the taxpayer and their professional advisors to decide the best way to proceed.