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Reverse Exchanges Under Section 1031
Overview of Reverse Exchanges
Internal Revenue Code Section 1031 and Regulations issued by the Internal Revenue Service (IRS) in 1991 provided investors with a detailed "safe harbor" procedure to exchange real property and defer payment of capital gains taxes. Under the 1991 Regulations, title to the property the investor desires to exchange (the "Relinquished Property") must be conveyed before the investor receives title to the property the investor desires to acquire (the "Replacement Property"). In the 1991 Regulations, the IRS specifically excluded "Reverse Exchanges" from the "safe harbor" provisions; that is, transactions where the investor conveys title to the Relinquished Property after acquiring title to the Replacement Property.
It was not until September 15, 2000, that the IRS issued safe harbor guidelines for Reverse Exchanges (Rev. Proc. 2000-37) which specify the procedures and conditions under which the IRS will not challenge the exchange because title to the Replacement Property is acquired prior to the conveyance of title to the Relinquished Property. This safe harbor provides a way for an investor who is faced with a situation where it is necessary to acquire the Replacement Property before the Relinquished Property is sold to accomplish an exchange under Section 1031 with a minimal amount of tax risk.
Reverse Exchange Safe Harbor Requirements
The Reverse Exchange safe harbor guidelines require that the exchange be structured as a "Title Holding Exchange,Ó where a Qualified Intermediary acquires and holds title to the Replacement Property in a "Qualified Exchange Accommodation Arrangement" under a written Exchange Agreement between the Qualified Intermediary and the investor. An important requirement for a valid Reverse Exchange is that legal title to the Replacement Property is held by an Exchange Accommodation Titleholder (EAT), and that the EAT is the owner of the property for federal income tax purposes. The EAT may be the Qualified Intermediary or a wholly owned entity that is disregarded for federal income tax purposes. In addition, the Relinquished Property in the exchange must be identified within 45 calendar days after title to the Replacement Property is conveyed to the EAT, and title to the Replacement Property must be conveyed to the investor within 180 calendar days of its acquisition by the EAT.
Structure of a Safe Harbor Reverse Exchange
Using the funds from the investor or a third party lender, the EAT acquires title to the Replacement Property under the terms of a sale and purchase contract negotiated by the investor. The EAT "warehouses" the Replacement Property until the investor arranges for the sale of the Relinquished Property, which is then sold under the terms of a sale and purchase contract negotiated by the investor. Thereafter, the property held by the EAT is sold to the investor as the Replacement Property in the exchange, and the investor or other lender is repaid the funds loaned to the EAT to the extent of the funds realized from the sale of the Relinquished Property.
The funding of the Replacement Property acquisition can be structured in several ways. The funds for the purchase may be cash advanced to the EAT by the investor and secured by the Replacement Property, or from financing provided by a third party lender to the EAT and secured by the Replacement Property and/or the Relinquished Property, or a combination of such sources. The Reverse Exchange safe harbor guidelines provide that the investor may guarantee the obligations of the EAT to a third party lender.
The Reverse Exchange safe harbor guidelines provide that the Replacement Property may be leased by the EAT to the investor during the period of time that the EAT holds title. By leasing the Replacement Property under a "triple net" lease, the investor has the full use and enjoyment of the Replacement Property and has the right to all rents and other income from the property, and is required to insure and maintain the property and pay all expenses of the property. The investor may also supervise the making of improvements to the Replacement Property while it is held by the EAT, and act as a contractor to make such improvements.
Accomplishing a Reverse Exchange requires solving certain problems that are different for each transaction. For example, some mortgage lenders will not lend funds to an exchange accommodator to acquire and hold title to the Replacement Property. Therefore, often other sources of financing must be found to acquire the Replacement Property, such as "carry-back" financing from the seller, or a short term portfolio loan from an institutional lender.
Reverse Exchanges Outside the Safe Harbor
Notably, the Reverse Exchange safe harbor guidelines provide they are not the exclusive way to accomplish a Reverse Exchange that qualifies for tax deferred treatment under Section 1031. However, investors considering a Reverse Exchange that does not comply with the safe harbor guidelines should note that there is little authority that directly supports tax-deferral treatment for such a transaction. To date the IRS has looked favorably on Title Holding Exchanges outside of the Reverse Exchange safe harbor guidelines. Investors should appreciate the risks in engaging in a Title Holding Exchange that does not comply with the Reverse Exchange safe harbor guidelines and consult with their tax advisor before deciding to engage in this type of exchange transaction.
Qualified Intermediary Services for Reverse Exchanges
National 1031 Exchange Service has assisted many investors in the reverse exchange of their properties both within and outside of the safe harbor guidelines. National 1031 Exchange Service has been very successful solving problems that arise in reverse exchanges, including assisting investors in arranging financing with institutional lenders to acquire Replacement Property to be held by an EAT.
The fee charged by National 1031 Exchange Service for accommodating a Reverse Exchange depends upon the complexity of the transaction, the value of the property held by the QEAA, and the length of time the QEAA holds title to such property. We invite your inquiries regarding our services and fees for accommodating Reverse Exchanges and whether this type of exchange is appropriate in your or your client's situation.
THE INFORMATION HEREIN IS NOT TO BE CONSTRUED TAX OR LEGAL ADVICE. IF TAX OR LEGAL ADVICE IS NEEDED, AN ATTORNEY, ACCOUNTANT OR OTHER QUALIFIED COUNSEL SHOULD BE CONSULTED.
