Problem Solvers: Reverse and Improvement Exchanges

In a typical tax deferred exchange under IRC Section 1031, a taxpayer sells the relinquished (old) property first and then purchases the replacement (new) property using the net proceeds from the sale. 1031 CORP. acts as Qualified Intermediary (QI) for purposes of moving the money and preparing all the necessary paperwork to have the sale and purchase transactions be part of the forward exchange.

However, there are instances where the taxpayer may need to take ownership of the new property prior to the sale of the old property. For example, the taxpayer may run the risk of losing that perfect replacement property or the sale of the relinquished property cannot be accomplished in advance of the purchase. 

By utilizing a “reverse exchange” under Rev. Proc. 2000-37, the IRS provides a “safe harbor” to permit a taxpayer to purchase the replacement property first. Reverse 1031 CORP., acting as the Exchange Accommodation Titleholder (EAT), structures the transaction in such a way to allow the taxpayer to buy the new property before the sale of the old property. 

In order to avoid the taxpayer taking title to replacement property prior to the sale of the relinquished property, the safe harbor rules require “parking” title with the EAT to hold until the relinquished property is sold as part of a regular forward exchange. As soon as the old property is sold in conjunction with 1031 CORP. as QI, the new property is conveyed to the taxpayer. The transfer of the replacement property by the EAT to the taxpayer is accomplished by deed or assignment of the membership interest in the new titleholder LLC so that the reverse exchange is wrapped-up within the 180-Day Exchange Period. 

While it is more common for the replacement property to be parked with the EAT, it is possible for the taxpayer to sell the relinquished property to the EAT first. As part of a regular forward exchange, 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 property. Then, using the exchange funds the taxpayer provided to the QI, the replacement property is purchased as part of a 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 sale may then be used to pay down any mortgage debt encumbering the old property with the balance to the taxpayer.   

Essentially the same reverse exchange procedures may also be used for purposes of constructing improvements to the replacement property as part of an “improvement exchange.” 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 back to the taxpayer by deed or assignment of the membership interest in the titleholder LLC. The enormous benefit with an improvement exchange is that the value of the property transferred back to the taxpayer includes not just the initial acquisition cost but also the value of all improvements the taxpayer is able to complete and pay for. It is important to note that all replacement properties as well as the proposed improvements described with as much specificity as is reasonably practicable need to be timely identified within 45 days. 

With 1031 CORP. as QI and Reverse 1031 CORP. as EAT, a taxpayer can utilize the reverse and improvement structures for purposes of maximizing the tax deferral benefits associated with performing like-kind exchanges of real estate under Section 1031.

As with all matters concerning 1031 exchanges, it is highly advisable for taxpayers to consult with independent professionals regarding the legal and tax consequences associated with any proposed transaction. Learn more about reverse exchanges.