1031 Reverse Exchanges
What is a Reverse Exchange?
In terms of complexity, a “Forward 1031 Exchange” is relatively simple, and is the most common type of tax deferred exchange. Section 1031 of the I.R.C. of 1986, as amended, provides “Safe Harbor” procedures for a Forward Exchange which include the use of a Qualified Intermediary (“QI”). The Relinquished Property (property to be transferred) is sold first and then the Replacement Property (property to be acquired) is acquired using the exchange proceeds from the sale of the Relinquished Property plus funds contributed or borrowed by the Taxpayer. The timing of the Forward Exchange begins on the closing date on the Relinquished Property.
A Reverse Exchange is more complex than a Forward Exchange. As its name implies, the Reverse Exchange is the mirror image of a Forward Exchange as the Replacement Property is acquired first. The complexity arises in a Reverse Exchange because the Taxpayer cannot own both the Relinquished Property and the Replacement Property at the same time. Either (1) the Replacement Property must be transferred to an “Exchange Accommodation Titleholder” (“EAT”) which is often the QI, while the Taxpayer continues to hold the Relinquished Property; or (2) the Relinquished Property must be transferred to the EAT prior to the Taxpayer acquiring the Replacement Property. In either case, a single member limited liability company (“SMLLC”) will be created to take title (“Park”) the property. The EAT will be the sole member of the SMLLC.
Section 1031 does not recognize the Reverse Exchange. While this type of exchange was long conducted using “Non-Safe Harbor” procedures, there were no “Safe Harbor” provisions for Reverse Exchanges prior to September 15, 2000, when Rev. Proc. 2000-37 was issued.
In today’s market, the flexibility of the Reverse Exchange makes it one of the most useful tools in the 1031 Exchange process. The Taxpayer may find a deal on a desirable property prior to even considering the sale of a Relinquished Property. Perhaps the Taxpayer may have a contract on a Relinquished Property which is scheduled to close before the Replacement Property closing but the contract is terminated due to financing contingencies, or any other reason, and there may not be enough time remaining prior to the closing on the Replacement Property to find another buyer. Of course, normal delays in the closing process can produce a situation where the Relinquished Property closing is delayed beyond the Replacement Property closing date. At least with a Reverse Exchange a Taxpayer has a chance of deferring the gains.
Reverse Exchange “Like-Kind” Requirements
Section 1031 permits a Taxpayer to relinquish property held for “productive use in a trade or business” or for “investment” in exchange for “like-kind” replacement property which is intended to be held for “productive use in a trade or business” or for “investment”. Real estate may be exchanged for like-kind real estate, and personal property may be exchanged for like-kind personal property. Real estate may not be exchanged for Personalty. The same requirements apply in a Reverse Exchange.
The world of like-kind real estate is broad and almost limitless. The only real restrictions are exchanging out of or into (1) a Taxpayer’s principal residence; (2) a Taxpayer’s second or vacation home (with some wiggle room); or (3) property held for sale (inventory). Real estate that qualifies can be a residential rental property; an office building, a shopping center, an oil and gas lease, a lease with at least 30 years remaining on its term; vacant land, etc., as long as they are held for “productive use in a trade or business” or for “investment”.
Like-kind Personal Property (tangible and intangible), however, is more restrictive, and is considered elsewhere on this website.
What are the Forms and Types of Reverse Exchanges?
There are two forms of Reverse Exchanges: The Reverse Exchange First (also known as “front-end”) and the Reverse Exchange Last (also known as “back-end”). In either case, the EAT is required to hold (“park”) title to one of the properties involved in the exchange (either the Replacement Property or the Relinquished Property) during the Reverse Exchange period for the Reverse Exchange to comply with the Internal Revenue Code guidelines.
Reverse Exchange First
In an Exchange First, the Exchanger transfers title to the Relinquished Property to the EAT and then acquires title to the Replacement Property. Though not as common as a Reverse Exchange Last, there are several situations where this type of reverse exchange is appropriate. One is where the Lender will not lend funds to the EAT for the acquisition of the Replacement Property but will lend to the Taxpayer. A second situation is where the EAT refuses to take title to the Replacement Property due to environmental (i.e. gas station) or other reasons. When the parked Relinquished Property is sold, the EAT or QI transfers the title directly to the ultimate buyer.
Reverse Exchange Last
In an Exchange Last, the EAT acquires the Replacement Property using funds provided by the Taxpayer. The purchase may be funded by a loan from a commercial lender who is willing to loan the purchase money to the SMLLC, on a non-recourse basis to the EAT, and accept the guaranty of the Taxpayer. Additional (or all) funds necessary to complete the acquisition are provided by the Taxpayer in the form of a loan by the Taxpayer to the EAT. When the Relinquished Property is sold, title to it is transferred directly to the Buyer, the funds from the sale are used to pay back the Taxpayer, and the EAT/QI transfers title to the Replacement Property to the Taxpayer.
Reverse Exchanges are necessarily more expensive due to their complexity. It is often better to do a Forward Exchange, if possible. EAT fees for Reverse Exchanges start at about $4,000 and increase depending on the complexity of the transaction. In addition to the EAT’s fee, there are legal fees, tax advisor fees, and costs of setting up the SMLLC. Depending on the jurisdiction of the Parked Property there may potentially be additional transfer and recordation taxes.
Reverse Exchange Types
“Safe Harbor” Reverse Exchange
Pursuant to Rev. Proc. 2000-37, the EAT takes control or “parks” the Replacement Property. The Taxpayer has 45 days from the closing date to identify the property to be relinquished and 180 days from the closing date to complete the exchange, i.e. close on the Relinquished Property transfer. If the transaction is properly structured and completed so that it meets all of the requirements of Rev. Proc. 2000-37, the Internal Revenue Service will treat it as a “safe harbor” exchange, rendering to the seller the concomitant tax benefits. While this is the safest and most secure Reverse Exchange for ensuring compliance with the tax code, it also has the most demanding time requirements.
Traditional “Non-Safe Harbor” Reverse Exchange
A Non-Safe Harbor Reverse Exchange may be used when the usual 180 day exchange period may not be met. A Non-Safe Harbor Reverse Exchange requires significantly more time to prepare, complex documentation, and a close working relationship with tax counsel and the QI to ensure that the transaction does qualify as a Reverse Exchange to the satisfaction of the Internal Revenue Service. Non-Safe Harbor Reverse Exchanges are generally more complicated and much more expensive to conduct.
There are instances where a Taxpayer may have more than one Relinquished Property intended to be exchanged into one Replacement Property. If the sale of one of the Relinquished Properties cannot be completed prior to the acquisition of the Replacement Property while the sale of another Relinquished Property will be completed in a timely fashion, a Hybrid Exchange is appropriate. A Hybrid Exchange is a combination of a Forward Exchange and a Reverse Exchange. A Forward Exchange is set up as to the property that closes prior to the settlement on the Replacement Property and a Reverse Exchange is set up as to the property that will not close prior to the acquisition of the Replacement Property. Title to the Replacement Property will be divided up into tenant in common (“TIC”) interests equal to the percentage interests of the property involved in the Forward Exchange and that involved in the Reverse Exchange. The Taxpayer will take title to the TIC interest associated with the Forward Exchange and an EAT, using a SMLLC, will take title to the TIC interest associated with the Reverse Exchange. At closing on the Replacement Property, the Forward Exchange is completed, and the Reverse Exchange begins. The timing of the Identification and Exchange periods are separate for the Forward and Reverse Exchanges. The 45 and 180 day periods for the Forward Exchange portion of the Hybrid Exchange will start on the sale of the Relinquished Property while the 45 and 180 day periods for the Reverse Exchange portion of the Hybrid Exchange will start on the day the Replacement Property is acquired. While complex, there are instances when a Hybrid Exchange will be beneficial to the Taxpayer.
Construction of Improvement Reverse Exchange
Like the “Safe Harbor” Reverse Exchange, the Construction or Improvement Reverse Exchange, also known as a “Build to Suit”, involves the “parking” of the Replacement Property with an EAT. The difference is that during the time that the Replacement Property is parked with the EAT, the Replacement Property will be improved through construction or other measures. The Build to Suit Reverse Exchange allows for the Replacement Property to be repaired, improved or even built by the Taxpayer through the use of leases and construction management agreements. This type exchange is more complex than a “Safe Harbor” Reverse Exchange and requires much more documentation and extensive consultations with tax counsel and the QI, and, again, is generally more expensive to conduct.
The identification of the Replacement Property in a Build to Suit Reverse Exchange is more exacting because the Replacement Property identified must be the property as it will be improved, not as it is acquired.
The time frames are also critical, because to qualify for safe-harbor treatment the Replacement Property must be conveyed to the Taxpayer at the end of the 180 day exchange period, whether the construction is completed or not. The value of the Replacement Property, for exchange purposes, will be the Replacement Property as improved on the date of transfer to the Taxpayer. If there are funds from the exchange that have not been used, these funds become “boot”. Unfortunately, the remaining exchange funds cannot be used to pre-pay for materials or other contract costs. The materials must actually be used in the construction to be accounted for. A “Non-Safe” Construction or Improvement Reverse Exchange may be structured if the construction period will exceed the 180 exchange period, however, this process is very complex and should only be attempted after consultation with an experienced tax counsel and QI.
Investment Assets and Reverse Exchanges
A Reverse Exchange is not limited to transactions involving real estate. A wide variety of investment assets (tangible and intangible) can be utilized to structure a Reverse Exchange to secure the tax benefits of the transaction. Aircraft, boats and art are examples of investment assets that have successfully been exchanged through a Reverse Exchange.
Questions about Reverse Exchanges and the ES Group:
- How many Reverse Exchanges have the managers at the ES Group facilitated? Over 100.
- Have all of the Reverse Exchanges facilitated by the ES Group been successful? Yes.
- What was the largest Reverse Exchange facilitated by the managers at ES Group? Over $360,000,000.00
- What was the smallest Reverse Exchange facilitated by the ES Group? $300,000.00.
- What types of personal properties are eligible for Reverse Exchanges? All asset classes – such as aircraft or construction equipment.
- Are businesses eligible for Reverse Exchanges? Yes. They can do reverse exchanges on equipment and business real estate. McDonalds could do reverse exchanges on the real estate and the ovens.
- Can the ES Group do Reverse Exchanges in all fifty states? Yes.
- Does the property acquired in a Reverse Exchange have to be in the United States or certain United States territories? Yes.
- Can I use a Reverse Exchange for a Tenant in Common (TIC) property? Yes, a Reverse Exchange is very useful in acquiring a TIC property as it affords the seller of a TIC property the flexibility to find a replacement TIC property without the time constraints of a Forward Exchange.
- What other advantages does the ES Group offer for a Reverse Exchange and other 1031 Exchanges? We can introduce you to certain tax-advantaged topics such as cost segregation, to accelerate depreciation on the replacement property.