An Overview of Reverse 1031 Exchanges
An investor who is doing a 1031 exchange may need to buy replacement property prior to the closing of the sale of the relinquished property, either because the relinquished property has fallen through, or because the investor has found the perfect replacement property before he is able to sell the relinquished property. In these cases, the investor can save his exchange by doing a “reverse” 1031 exchange.
WHAT IS A REVERSE EXCHANGE?
In a reverse exchange, the investor is able to close on the acquisition of the replacement property before the relinquished property is sold to a third party buyer. This is done by having a limited liability company which is owned by First American Exchange take title to either the replacement property or the relinquished property. The two procedures for doing a reverse exchange are explained in more detail below.
In each case, First American Exchange acts as the qualified intermediary and also creates a limited liability company that temporarily takes title to the property. All of First American’s reverse exchanges are done in accordance with the IRS’s safe harbor rules of Revenue Procedure 2000-37, which means that the entire transaction must be completed within 180 days of the first closing. Under the safe harbor rules, the entity that takes title to the property is called an “exchange accommodation titleholder” or “EAT.” While the EAT owns the parked property, the investor pays all expenses of that property and collects all income produced by the property. The benefit of the safe harbor is that the EAT can be considered the owner of the parked property for tax purposes, even though the EAT does not have the benefits and burdens of ownership.
A reverse exchange is only possible if it is set up before the investor takes title to the replacement property. In fact, because of the financing and real estate issues that typically arise in a reverse exchange, it is advisable to set it up as early as possible before the replacement property closing.
HOW ARE REVERSE EXCHANGES STRUCTURED?
A. “Exchange Last” Reverse Exchange
In an “Exchange Last” reverse exchange, the EAT takes title to the replacement property at the scheduled closing. If the investor is borrowing money to acquire the replacement property, the loan is typically structured with the EAT as the borrower. In addition, the EAT borrows the equity from the investor.
The EAT and the investor enter into a “Qualified Exchange Accommodation Agreement” and a lease. These documents give the investor full control over the property, require the investor to pay all expenses of the property and give the investor all rights to receive the income from the property. The EAT holds title to the replacement property but does not otherwise act as an owner of the property.
Once the relinquished property is ready to be sold to the third party buyer, First American as the qualified intermediary sells the relinquished property to the buyer and uses the funds to acquire the replacement property from the EAT. As in any exchange, First American does not acquire title to the relinquished or replacement properties, as direct deeding is allowed. At the final closing, the EAT transfers the replacement property to the investor and the EAT receives the exchange funds as the purchase price for the replacement property. The EAT then pays off the loan to the investor using those exchange funds. Essentially, the investor is paid back for the cash he deposited up front, as a loan to the EAT, to acquire the replacement property. All of this must happen within the 180-day parking period.
B. “Exchange First” Reverse Exchange
In an “Exchange First” reverse exchange, the EAT takes title to the relinquished property. This must happen prior to the closing of the replacement property. One way to look at it is that the EAT is stepping into the shoes of the buyer of the relinquished property, either because the investor has not yet found a buyer or the buyer is not ready to close.
The purchase price is the investor’s estimate of the fair market value of the property. The EAT pays the purchase price by taking the property subject to any existing financing and borrowing the equity from the investor. Because of this, the investor is actually taking on an additional role as a lender. The EAT uses the borrowed funds to pay for the relinquished property and they become exchange funds. First American Exchange uses those exchange funds to acquire the replacement property.
As with an exchange last transaction, the EAT and the investor enter into a “Qualified Exchange Accommodation Agreement” and a lease. These documents give the investor full control over the relinquished property, require the investor to pay all expenses of the relinquished property and give the investor all rights to receive the income from the relinquished property. The EAT holds title to the relinquished property but does not otherwise act as an owner of the property.
Although the exchange is completed up front, in order to make this type of reverse exchange work, the investor must arrange for a third party buyer to acquire the relinquished property and that sale must close within 180 days after the date that the EAT takes title to it. The documentation between the EAT and the investor will provide that the investor gets all of the proceeds from the sale of the relinquished property at this closing, even if the property is sold for more than what was originally planned. Excess funds may result in some taxable boot to the investor.
C. Pros and Cons of Exchange Last vs. Exchange First Transactions
Each method of doing a reverse exchange has its own benefits and drawbacks, which are discussed in this section.
Benefits of Parking the Replacement Property (Exchange Last)
Although it is possible to park either the replacement property or the relinquished property, it is typically easier to ensure that the transaction is completely tax deferred if the EAT takes title to the replacement property.
In an exchange last reverse, the investor can borrow the funds that he expected to get from the relinquished property and then pay the loan down after the relinquished property closes but before the investor takes title to the replacement property. This gives the investor access to funds before the relinquished property closes, but allows the investor to pay down the loan so that the investor can invest all of the exchange funds into the replacement property and accordingly completely defer all tax.
Another benefit of taking title to the replacement property is that the investor does not have to decide immediately which of his properties he is going to dispose of in the exchange. The investor has 45 days from the closing of the replacement property to identify in writing what he is going to sell.
Drawbacks of Parking the Replacement Property (Exchange Last)
If the EAT takes title to the replacement property and the investor is borrowing money secured by that property, the EAT signs some or all of the loan documents. The loan must be completely non-recourse to the EAT, which means that the EAT has no personal liability to repay the loan. The rules allow the investor to guaranty the loan if needed. Nevertheless, some lenders do not feel comfortable with the EAT as the borrower, particularly if the loan is secured by a one to four unit residential property. If the parked property is replacement property, it is essential that the investor discuss the reverse exchange with his lender and tax advisor as soon as possible.
Benefits of Parking the Relinquished Property (Exchange First)
The principal benefit of having the EAT take title to the relinquished property is that it avoids the EAT having to sign loan documents when the investor is getting a loan secured by the replacement property. One caveat is that if there is an existing loan secured by the relinquished property, the investor must determine whether that lender has a right to approve the transfer to the EAT and if so, should get that lender’s consent to the transfer.
Drawbacks of Parking the Relinquished Property (Exchange First)
When the EAT takes title to the relinquished property, the investor must invest enough equity into the replacement property as of the initial closing of that property to at least equal the equity that the investor expects to receive from the relinquished property once it is sold to a third party. In other words, it is not possible to over-borrow on the replacement property and then pay down the loan later. Because of this limitation, a reverse exchange using the relinquished property only works when the investor has access to cash from a source other than the replacement property in order to fund the equity of the replacement property up front.
Another drawback is that the investor must know up front which property he will dispose of in the exchange. This is because the exchange happens at the beginning of the process, and the EAT takes title to the relinquished property before the closing of the replacement property.
Other Factors to Consider
Sometimes there are other factors which will encourage the EAT to take title to the replacement property rather than the relinquished, or vice versa. For example, it may be more costly to have the EAT take title to one of the properties because of transfer tax or other closing expenses. One property may be contaminated, which may make it difficult for the EAT to take title to it. Every reverse exchange is unique, and it is important to discuss your situation with First American Exchange and your tax advisor.
WHAT DOES THE INVESTOR NEED TO DO?
There are several items that the investor will need to deliver to First American Exchange in order to set up the exchange.
- For all commercial properties (i.e., not 1 to 4 unit residential properties), the investor must obtain a Phase I environmental report that shows that the property is not contaminated with hazardous materials.
- The property insurance for the parked property should reflect that the EAT owns the property. In addition, the investor must obtain liability coverage for the property that is acceptable to First American Exchange and covers both the investor and the EAT.
- First American Exchange will need a copy of the title report and purchase contract (if there is one) for the properties.
- If there is a third party lender, it is important for the investor to discuss the transaction with the lender and ensure that the lender is willing to cooperate in the reverse exchange. If the EAT will hold title to the replacement property, the lender will need to agree to include special non-recourse language in the loan documents, and permit the transfer of the property at the end of the exchange from the EAT to the investor.
- The investor should gather information on the potential cost of the reverse exchange and discuss the transaction with his tax advisor and/or lawyer before going forward with any reverse exchange transaction.
WHAT ARE THE POTENTIAL COSTS?
Reverse exchanges are more complicated than deferred exchanges and therefore are more time consuming and costly. This section discusses some of the factors that may increase the costs of a reverse exchange.
First, the fee to First American Exchange will be a higher fee than the fee for a deferred exchange, for several reasons. In a reverse exchange, the EAT actually goes on title, which does not happen in a deferred exchange.
Although the documentation attempts to limit the EAT’s risks with respect to the property, there is an inherent risk involved with the ownership of real estate. In addition, the documentation is more complicated and the closings often involve negotiations with numerous parties, such as lenders and property insurers. The EAT also must reflect on its tax return that it owns title to the property during the parking period.
Another reason for higher costs is that there will be three closings instead of two in every reverse exchange. There is always one closing for the relinquished property and one for the replacement, but in a reverse exchange there will be an additional closing because the EAT temporarily takes title to one of the properties. This results in double closing costs, such as transfer taxes, title insurance, escrow fees and other costs and fees. There are ways of minimizing or eliminating some of these costs, such as ordering a title insurance binder or in some cases, assigning the membership interest in the EAT at the end of the exchange, and investors should discuss these options with First American Exchange and their own tax advisors.
There may be other increased costs, such as loan fees, tax advisor fees and legal fees. The investor should compare these costs with the amount of tax that will be deferred in the exchange.
FAILED REVERSE EXCHANGES
If the investor is unable to find a buyer of the relinquished property during the 180 day period, the EAT transfers the property it is holding to the investor. If this happens, the investor has lost an opportunity to trade into the replacement property, and has paid some fees for the reverse which will not be refunded. However, the investor can eventually do a deferred exchange with that relinquished property once it is ready to close, if the investor plans to buy more replacement property.
Reverse exchanges are a tool that investors can use to defer capital gains tax even when the replacement property must close before the relinquished property closes. An investor considering a reverse exchange should contact First American Exchange as early in the process as possible, and also should seek the advice of his personal tax advisor.