1031 Turned Upside Down: How A Reverse Exchange Can Save the Day
Most investors know that in order to complete a successful 1031 exchange, they sell their relinquished property and have 180 days to buy the replacement property. What can be done when the perfect replacement property is found and must be acquired before the existing property can be sold? Must all the benefits of a 1031 exchange be lost if events are out of order? The IRS, recognizing that this situation sometimes occurs, released guidelines in 2000 to show how this type of transaction could be completed and still qualify as a valid exchange. This technique is referred to as a “reverse exchange” which allows the taxpayer to capture (although not personally acquire) their “target property” and park it until their relinquished property is sold. Then they can take title to the parked property to complete the exchange, successfully completing their exchange.
There are two primary types of reverse exchanges: one is commonly termed “exchange last” in which the replacement property is parked, while the other is named “exchange first” in which the relinquished property is parked. The “exchange last” technique is used in a clear majority of transactions, so we will focus solely on this approach.
When looking at the basic elements of this technique, you can see that there are a number of instances in which this type of reverse exchange could be very effective:
1. A reverse exchange works when you want to capture the perfect replacement property before you sell. In a quick-moving real estate market where attractive property is hard to find and quick to go under contract, there may be investors who are not willing to risk selling their existing property without knowing that they will find a viable replacement property during the 45-day identification period. This investor may want to find and capture the perfect replacement (or target) property before closing on the sale of their relinquished property. (This is especially true for those exchangers who operate a trade or business from their relinquished property and cannot afford to gamble they will find an ideal replacement property in time. They need a seamless transition, or their day-to-day business may suffer.)
2. A reverse exchange can be ideal when you are forced to close quickly on the ideal replacement property. A reverse works when the timing of his anticipated sale won’t line up to allow a standard exchange. Consider an exchanger who already has the relinquished property under contract with an anticipated closing date 60 to 90 days out. He has also found a great property to acquire, but the seller insists on a closing within 30 days, throwing the proper sequence of events out of order.
3. A reverse also works to save a replacement property from being lost. A reverse can save the day when the unexpected happens: a relinquished closing falls through. For example, an investor has her relinquished property under contract. She has also placed a very desirable replacement property under contract and has arranged that closing date for 5 days after her relinquished closing. At the last minute, the relinquished property sale falls apart, putting her exchange in jeopardy. The investor still wants to use the property as her future replacement property, but the seller is not willing to extend the closing date and wait for her to start the process of selling her relinquished property again. In this instance, if the investor has the financial wherewithal, the replacement property can be “parked” for her while she sells her existing property.
The guidance issued by the IRS under Revenue Procedure 2000-37 created a series of steps that allows the taxpayer to address these real-world scenarios. Pursuant to this guidance, the taxpayer can insert an independent, third-party that is referred to as an Accommodation Titleholder (or AT) that can acquire – or “park” – what will be the replacement property. The arrangements for this type of transaction can be very “friendly”, eliminating almost all the potential risk to the AT. In essence, the AT does not have to have any of the burdens and benefits that typically come with ownership. They serve as a conduit entity. Specifically, the party acting as the AT:
1. Does not need to contribute equity in the transaction;
2. Is not required to guarantee any debt to acquire the property;
3. Can borrow funds from the taxpayer to acquire the property at non-market rates;
4. Can be indemnified against any costs, expenses or liabilities by the exchanger in the agreement;
5. Can transfer the use and obligations of the target property to the taxpayer through a lease; and
6. Can hire the taxpayer as the construction manager for any improvements made.
Though this type of transaction is more costly and complicated than a standard delayed exchange done in normal order, it is often worthwhile given the tax consequences that may be triggered.
Here is a summary of the basic steps in this type of reverse exchange:
1. The taxpayer hires an AT to acquire the target property.
2. The taxpayer loans or causes a third-party lender to loan the funds to the AT for the acquisition. The exchanger guarantees the loan, and agrees to indemnify the AT. The replacement property is acquired by the parking entity (AT).
3. The AT gives control of the property to the taxpayer through a NNN lease during the exchange period.
4. The relinquished sale takes place and a qualified intermediary holds the proceeds (just as in a standard exchange.)
5. With the relinquished proceeds forwarded by the QI, the exchanger then buys the target property from the AT by the 180th day, either directly (with a deed) or by purchasing the ownership interest in the single-purpose parking entity (saving transfer taxes.)
There are two primary challenges regarding this type of transaction. Because the exchanger does not have any cash from the sale of their relinquished property to buy the new one, they must have the financial wherewithal to lend funds to the AT for the acquisition of the eventual replacement property. If they only have some of the funds needed, they must be able to arrange for a lender to loan the remaining balance needed. Secondly, the exchanger must be willing and able to take the risk that the relinquished property may not be sold within 180 days. In this worst-case scenario, the investor is left with two properties, no tax savings or both.
In summary, a reverse exchange is an important strategy that can be employed to solve a number of real world challenges. Because the transaction is approved by the IRS, this technique is not considered aggressive tax planning, though it is more costly and more complicated than your standard exchange. While there are many benefits to implementing a reverse exchange, the taxpayer must be fully aware of the challenges and the additional cost associated with this type of transaction. It is important to first consult your tax advisor regarding this type of transaction and also that you use the services of an experienced Accommodation Titleholder (AT) service provider.