What to Know About Reverse Exchanges
What if a taxpayer wants to purchase their replacement property before they are able to sell their relinquished property? In many situations, the taxpayer thinks that they have no option to effect a 1031 Exchange in such a situation. Fortunately, there is a solution.
The reverse exchange allows for this type of structure. The transaction will need to be structured so that the taxpayer never holds title to both the relinquished property and the replacement property at the same time.
The transaction will be structured either as an Exchange Last or Exchange First exchange.
Key points to remember:
- This process was given a safe harbor status by the IRS through Revenue Procedure 2000-37 (Rev Proc 2000-37).
- The timeframes for the standard exchange apply for a Reverse Exchange as well;
- 45 calendar days to identify replacement (or relinquished property)
- 180 calendar days from the date of the first closing to complete the exchange
In the exchange last transaction (which is most common), the EAT will take title to the replacement property at the closing. This closing will need to be funded by the taxpayer as Security 1st Exchange has not yet received funds from the closing of the relinquished property. The taxpayer can coordinate with a lender to get a loan for this closing, but since the EAT is the entity taking title, the taxpayer will need to work with the lender to understand that the EAT is the borrowing entity.
Once the replacement property has closed and is under the EAT entity, the EAT will lease the replacement property to the taxpayer. This lease will provide that the taxpayer receives all of the benefits and burdens of ownership, including the receipt of income generated from the property and will be required to pay all of the expenses of ownership as well.
At the same time, the taxpayer is working to sell their relinquished property. Once a buyer is found and a closing occurs, the proceeds from the sale are transferred to the Qualified Intermediary. With the proceeds, the taxpayer will acquire the replacement property from the EAT. If there are remaining funds, the taxpayer may acquire additional replacement properties as part of a forward exchange or may decide to take the balance of funds when available and pay taxes (boot).
In the exchange first scenario, the EAT will take title to the relinquished property prior to the closing of the replacement property. The EAT will lease the relinquished property to the taxpayer, wherein the lease provides that the taxpayer receives all of the benefits and burdens of ownership, including the receipt of income generated from the property and will be required to pay all of the expenses of ownership as well.
Since the EAT now has ownership of the relinquished property, the taxpayer is allowed to take title to the replacement property. And with the taxpayer taking title, it will normally be simpler to find a lender that would comply with this type of exchange.
An issue that comes up in this type of reverse exchange is if the taxpayer has a mortgage on the relinquished property. If they want to transfer this property to the EAT with a loan in place, many lenders will not cooperate.
The last step is for the taxpayer to get their relinquished property under contract and closed. The closing funds from the relinquished property are transferred to Security 1st Exchange as QI and then those proceeds can be used to pay off any debt incurred by the EAT on the acquisition.
As with any exchange, a taxpayer should consult with their counsel or tax professional before considering a reverse exchange. And reach out to the professionals at Security 1st Exchange for more information.