Delayed or Reverse?
Risk, asset management and economics. These criteria should all be carefully evaluated when developing an optimal exchange strategy.
First and foremost, the optimal strategy should be the one that is less risky. There are two primary categories of risk in 1031 exchanges: risk of a failed exchange, causing a loss of the tax deferral, and risk associated with the security of the assets involved in the exchange.
Frequently, the risk of a failed exchange is outweighed by the need for the Exchangor to have the cash proceeds from the sale of the Old Property available to for the purchase of the New Property. In these cases, there really is no choice but to use a delayed exchange and the Exchangor assumes the risk associated with missing the 45-day identification deadline and the 180-day exchange completion deadline. If the exchange fails, the cash is returned to the Exchangor and there is no deferral of the capital gains tax. In many markets and for many types of assets, it simply is more likely that an exchange will fail if the Old Property is sold first with hopes of finding and closing a transaction for the New Property within the deadlines. In real estate markets with low inventories of desirable commercial real estate, for example, it makes more sense in many cases to take the time to find and negotiate the purchase of a New Property than it does to sell the Old Property and risk losing the exchange because a desirable New Property cannot be found within 45 days and closed within 180 days. A reverse exchange starts the exchange clock when the New Property is acquired rather than when the Old Property is sold and thereby reduces the risk of deadline-related failure. The ID requirements are often easily satisfied because the Old Property is already known to the Exchangor. And, there is more flexibility in a reverse exchange as any one of potentially many properties that are owned by an Exchangor can be identified, as long as the identification is made according to the rules. There is also flexibility regarding the 180 day completion deadline when using a reverse exchange. The exchange deadlines can be met even if the Old property is not sold to its ultimate buyer during the exchange period. This involves the transition of the ownership of the Old Property to a new EAT and involves additional effort and cost. However, the ability to extend an exchange in this fashion simply does not exist using a deferred exchange.
Concerning the risk associated with entrusting assets to a QI, it is crucial for Exchangors to know their QI and have detailed visibility into their approach to protecting the assets they hold. Exchangors whose optimal strategy involves delayed exchanges should look for provisions such as segregated or trust accounts for exchange proceeds, dual signature disbursement policies, real-time visibility into the bank accounts in which funds are being held and investment policies implemented by the QI that provide appropriate security and liquidity. In addition, Exchangors should gain enough visibility into the operations of their QI to determine that they have adequate Fidelity Bond coverage and are not in danger of becoming insolvent. See our section on Asset Security for more information on how to make these determinations.
In reverse exchanges, the Accommodator (hopefully ES Group!) does not hold cash but does hold title temporarily to the assets parked in the EAT. Each Exchangor receives a fully perfected security interest in the EAT so that it simply is not possible for the assets to be liquidated by the Accommodator without the permission of the Exchangor. The gives the Exchangor ultimate control even though the assets are parked in a separate entity for the purposes of the exchange. Secondly, the EAT should provide a significant level of protection from insolvency of the Accommodator or bankruptcy remote-ness. As you’ve no doubt come to expect, ES Group provides a fully perfected security interest in each reverse exchange we perform and we have three levels of bankruptcy remoteness that can be chosen by the Exchangor – ranging from a 2-tiered LLC structure to an independently-managed LLC with an operating agreement fully customized for the protection of the Exchangor.
Secondly, the optimal exchange strategy provides the most effective asset management to the Exchangor. Asset management means making assets available to those who use them and it means effectively positioning assets for development of an optimal exchange strategy. For some types of assets, it does not make sense to sell the Old Property – thereby making it unavailable to the Exchangor – if there will be any substantive delay in acquiring the New Property. The classic examples here involve personal property (non-real estate) assets such as aircraft. If a company has an airplane used to provide flexible, quick and convenient transportation to its senior executives, it makes no sense to sell the old aircraft before acquiring the new aircraft because the executive would have to fly commercial like the rest of us and they’d fire the person managing the assets. Similarly, vehicles like rail cars or tractor/trailer combinations are productively deployed and to take them out of service without having replacements is likely to be a poor approach to asset management. Reverse exchanges are the strategy of choice for leaving assets in productive deployment during a 1031 exchange.
Thirdly, the optimal exchange strategy is one that is more cost effective for the Exchangor. Delayed exchanges involve the liquidation of the Old Property and entrusting the proceeds to a QI. These funds should not be invested in risky, higher yield instruments unless the Exchangor explicitly agrees. In most cases, the QI shares the interest earned on the proceeds with the Exchangor. Therefore, earnings on the exchange proceeds that inure to the Exchangor during the exchange period will be modest at best. In general, assets held for income or appreciation are usually providing income or increasing in leverage. Hence, to sell such an asset prematurely means that that stream of income or appreciation is stopped when the asset is sold. When lost income or appreciation is factored into the computation of the cost, reverse exchanges are often less expensive. After all, if holding cash were a better investment, nobody would own investment assets. This is especially true when a significant portion of the return from the exchange proceeds is kept by the QI.
As an example, one which may be somewhat synthetic and simplistic, consider the following hypothetical situation involving two income-producing investment properties:
- FMV of $2,000,000
- Basis of $1,000,000
- Debt of $600,000 and equity of $1,400,000
- Gross income of $7,000 per month, based on 6% return on equity
- Monthly depreciation of $1,709 based on the standard real estate assumptions of a 39 year window applied to 80% of the basis.
- Monthly income of $5,730 assuming a combined tax rate of 24%.
- FMV of $3,000,000
- Equity is transferred from the Old Property and is $1,400,000
- Similar return on equity (6%)
- Monthly depreciation of $5,128 assuming that the basis of the Old Property will be transferred and that the same depreciation rules apply to the delta between the FMVs of the two properties ($1,000,000)
- Monthly income of $6,551 assuming the same tax rate
If a delayed exchanged is used:
- Assume an exchange fee of $750 and interest paid on the exchange proceeds at a rate of 1% while the proceeds are held by the QI.
- Since the Exchangor has relinquished the Old Property and has not yet acquired the New property, there is no net income during the exchange period.
- If the exchange period is 3 months, then the Exchangor will earn a total of $2,750 (3 months of interest at 1% less the exchange fee).
If a reverse exchange is used:
- Assume that the exchange fee is $5,000 and the exchange lasts for 3 months.
- The Exchangor benefits financially from both the Old and the New Properties during the exchange.
- During the exchange period, net income from the Old Property will be $17,191 and net income from the New Property will be $19,652.
- There will be an expense associated with the cost of financing the New Property acquisition (assume $1.4 million in cash taken from accounts bearing interest at 3.5%)
- Also, the Exchangor may not take depreciation on the property held by the Accommodator during a reverse exchange. Accordingly, in an Exchange First, there will be a loss of $1,231 in depreciation benefit and in an Exchange Last, there will be a loss of $3,692.
- Using an Exchange First, net income to the Exchangor during the exchange period will be $18,312.
- Using an Exchange Last, net income to the Exchangor during the exchange period will be $15,901.
Please contact us if you’d like to discuss this analysis further for your particular situation.