The Reverse Exchange
Background and Overview
A forward deferred exchange is the most common structure for a 1031 tax-deferred exchange. It is, quite simply, the sale of the relinquished property by the taxpayer followed by the purchase of qualifying replacement property by the taxpayer. The taxpayer has 180 days from closing on their relinquished property to take title to the replacement property and must identify their prospective replacement properties in the first 45 days.
A reverse exchange, by contrast, is used most commonly where the taxpayer must acquire the replacement property for their exchange prior to the sale of their relinquished property.
In situations where the taxpayer cannot close on the sale of their relinquished property prior to closing on the purchase of the replacement property, a properly structured and completed reverse exchange may provide the taxpayer with all the tax deferral benefits of a “normal” forward exchange. The IRS has created safe harbor provisions for reverse exchanges that use the structures described below.
Structuring a Reverse Exchange
A reverse exchange requires the use of an Exchange Accommodation Titleholder (EAT). The role of the EAT is to take and hold title to one of the properties involved—either the taxpayers’ relinquished property or the replacement property. The reason is that the taxpayer is prohibited by the IRS’s 1031 rules from being on title to both properties at the same time.
Using the EAT, the reverse exchange can be accomplished using one of the two following structures:
Exchange First, or Parking the Relinquished Property
The EAT takes title to the relinquished property as the substituted buyer. This is also referred to as “parking” or “warehousing” the relinquished property. Since the taxpayer and the EAT are simulating a real sale, the taxpayer must estimate what they would sell the property for if they had a “real” buyer and must also estimate what they would expect to receive in net proceeds, also known as exchange equity, if a real sale had occurred.
The exchange equity is then used immediately to buy the replacement property and the exchange is complete. The EAT will stay on title to the taxpayer’s relinquished property until the “real” buyer is ready to close. Title is then transferred from the EAT to the buyer and the net proceeds from that sale are used to reimburse the taxpayer for the exchange equity they had advanced.
Exchange Last, or Parking the Replacement Property
In this structure, the EAT takes title to the replacement property using funds provided by the taxpayer. The taxpayer holds a note and deed of trust to the property as the “lender.” Title to the property is “parked” until the relinquished property can be sold. When the relinquished property is sold, it is treated as the first part of the exchange. The seller’s proceeds are sent to the intermediary as exchange funds. These funds are then used to “buy” the replacement property held by the EAT and transfer title to the taxpayer.
Benefits
As mentioned above, a successfully completed reverse exchange offers the same tax deferral benefits as a forward exchange. The taxpayer is able to defer the recognition of gain associated with the sale of the relinquished property.
There are also some taxpayers who feel that securing the replacement property first relieves the burden imposed by the 45-day identification rule.
Disadvantages
Where the EAT takes title to the relinquished property, the taxpayer must advance funds without having actually sold their relinquished property. There is also some guesswork in estimating what the actual sales price and net proceeds will be. If the taxpayer underestimates and receives more in equity or price when the property actually sells, they may have some unexpected gain. The relinquished property must actually be sold within 180 days or the exchange will likely fail.
Where the EAT takes title to the replacement property, the taxpayer must also provide funds to purchase the replacement property. They do not yet have the proceeds from the sale of their relinquished property so they will need to have funds from another source, obtain a bridge loan, or accomplish the often difficult tasking of finding a lender who is willing to finance the purchase where the EAT will be taking title rather than the taxpayer.
In either type of reverse exchange, the taxpayer should consider whether their tax liability outweighs the significantly higher costs of completing a reverse exchange. The additional costs include the EAT fees, intermediary fees, and two sets of title and escrow fees for both title transfers, as well as applicable city and/or county transfer taxes.
There are other options to undertaking a reverse that the taxpayer might consider. One option is a properly structured lease-option arrangement that allows the taxpayer to secure the replacement property while waiting for their relinquished property to sell. The taxpayer could also negotiate with the seller of the replacement property to extend the closing by offering a larger and/or non-refundable deposit.
There are many benefits to using a reverse exchange transaction. While this article attempts to briefly describe the reverse exchange, it is very important that any taxpayer entering into an exchange first consult with a trusted tax advisor to evaluate their options and ensure they can comply with the strict requirements of IRC Section 1031.
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1. If the taxpayer is unable to sell the relinquished property within the 180 day period there are several possible tax implications: If the replacement property had been parked, the replacement property will be deeded back to the taxpayer by the EAT and the taxpayer will be treated as having purchased the parked property on that date. The taxpayer may want to disregard the entire failed QEAA transaction and the taxpayer will be treated as having simply acquired another piece of real estate.
If the relinquished property had been parked, and the taxpayer has already filed a tax return reporting the exchange and a carryover basis in the replacement property, it would seem the transfer of the relinquished property back to the taxpayer from the EAT would give the taxpayer a new fair market value basis in the relinquished property, or can the taxpayer disregard the parking arrangement and simply treat the replacement property as another piece of real estate they have acquired? The guidelines contained in IRS Revenue Procedure 2000-37 do not answer these questions.
reprinted by permission of Alison King, Esq.