Alleviating Stress and Maximizing Opportunities
The real estate market remains very competitive, and the short 45-Day Identification Period creates anxiety for investors contemplating a 1031 exchange. No one wants to sell their old property without being certain you can replace it with something better. In the last year, 1031 CORP. has seen countless buyers fall apart while the Exchanger is waiting to close on their relinquished property. These are scenarios our Exchange Team are discussing with Exchangers daily.
The tight real estate market of the last four years has led to more investors opting to eliminate the stress of the 45-Day Identification requirement by utilizing a reverse exchange. These savvy investors are taking their time to find their perfect replacement property before putting their old property on the market. A reverse exchange takes the pressure off and eliminates the time clock.
What Is a Reverse Exchange?
A reverse 1031 exchange allows the Exchanger to structure their exchange backward. They are ready to acquire the replacement property but are not ready to close on their old property. Maybe you don’t want to list the old property for sale until after your tenant’s lease expires or perhaps the buyer’s financing fell through a week before closing. Finding the right replacement property is now the most challenging part of a 1031 exchange but the reverse exchange can help.
A 1031 exchange is the continuation of your old property 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. The Rec. Proc. uses a structure called a Qualified Exchange Accommodation Arrangement (QEAA) to allow title of (usually) the replacement property to be “parked” or held by an Exchange Accommodation Titleholder (EAT) until title to the relinquished property is transferred to a buyer. The EAT is typically a single-member limited liability company in which the sole 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.
How Does a Reverse Exchange Work?
Financing and the anticipated length of time the EAT is expected to "park" title to your property are the determining factors when deciding whether the EAT takes title to your replacement or relinquished property. In most situations, the replacement property is parked so we will discuss that structure.
- 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 the 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 requiring 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 identify the 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.
Things to Keep in Mind
- At the end of the exchange, the equity in the replacement property must be equal or greater than the equity in the relinquished property and the value must be greater.
- Any money loaned to the EAT is secured through a promissory note or mortgage.
While there are additional costs and reverse exchanges require more planning, they give you more time to find a replacement property that works for you. 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.
