Reverse 1031 Exchange Transactions

By structuring a reverse 1031 exchange, you can acquire your replacement property before you sell your relinquished property. This strategy is particularly beneficial in markets where demand is high and inventory is low.


Department of the Treasury Issues Guidance on Reverse 1031 Exchanges


The issuance of Revenue Procedure 2000-37 on September 15, 2000, which provides safe harbor rules for reverse 1031 exchange transactions, has increased the number of such reverse 1031 exchange transactions over the past few years. Prior to this, taxpayers completed reverse exchanges with little guidance from the Internal Revenue Service. While these safe harbor rules have clarified issues surrounding reverse 1031 exchanges and provided a much higher comfort level than before, they also leave a lot of unanswered questions. Consultation with a knowledgeable tax and legal advisor is therefore essential when structuring a reverse 1031 exchange transaction.


In a reverse 1031 exchange, an Exchange Accommodation Titleholder (EAT) holds the Qualified Indicia of Ownership, customarily the legal title (fee interest), of the property on your behalf. An 1031 Exchange Accommodator (Qualified Intermediary) facilitates the 1031 exchange. The EAT and the Exchange Accommodator (Qualified Intermediary) may be the same entity, although it is not advisable. In order to better protect both the Exchangor (taxpayer) and the exchange company, there should be a separate entity that functions as the Exchange Accommodation Titleholding from the entity that functions as the Qualified Intermediary.


Replacement or Relinquished Property Parking


You may “park” either your replacement or your relinquished property with the EAT. When you transfer the property to the EAT, you must have the bona fide intent that the property represents either replacement or relinquished property in a whole or partial IRC Section 1031 tax-deferred exchange.


The Exchange Accommodation Titleholder (EAT)


The EAT must meet all of the following requirements:


* Hold Qualified Indicia of Ownership, customarily the legal title (fee title), at all times from the date of acquisition of the property until the property is transferred.
* Must not be a disqualified entity or the taxpayer.
* Be subject to federal income tax. If the EAT is treated as a partnership or S corporation, more than 90% of its interests or stock must be owned by partners or shareholders who are subject to federal income tax.


Qualified Indicia of Ownership


Qualified Indicia of Ownership are defined as any of the following:

* Legal title to the property.
* Other indicia of ownership of the property that are treated as beneficial ownership of the property under principles of commercial law (i.e. a contract for deed).
* Interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes, such as a single-member LLC; this entity must hold either legal title to the property or other Qualified Indicia of Ownership.


Qualified Exchange Accommodation Agreement


The EAT and the Exchangor (taxpayer) must execute a written Qualified Exchange Accommodation Agreement (QEAA) within 5 days after the Qualified Indicia of Ownership are transferred to the EAT. The QEAA must specify the following:


* The EAT is holding the property for your benefit in order to facilitate an exchange under the like-kind exchange rules and Revenue Procedure 2000-37.
* The EAT and you agree to report the acquisition, holding and disposition of the property on your federal income tax returns in a manner consistent with the agreement.
* The EAT will be treated as the beneficial owner of the property for all federal and state income tax purposes.


Legal / Contractual Arrangements


Under the QEAA, the EAT and you may enter into a variety of legal or contractual arrangements. You will be responsible for any losses or receive any profits generated from the property during the holding period. You will lease the property from the EAT under a triple-net lease. You may assume management responsibilities; or the EAT and you may agree to hire an outside management firm.


Time Limits for Identifying and Transferring Property


Transfer and identification requirements are consistent with those in a Forward (Delayed) Exchange.


In an exchange last parking arrangement (see below), you must identify the relinquished property 45 calendar days after the transfer of Qualified Indicia of Ownership of the replacement property to the EAT in a manner consistent with the principles of a Delayed Exchange.


When you transfer the relinquished property to the EAT, you do not need to identify a replacement property because the simultaneous exchange takes place at the commencement of the transaction. (See below)


Within 180 days after the transfer of the Qualified Indicia of Ownership of the property to the EAT, the property must be transferred to the taxpayer as replacement property; or to an entity, who is not the taxpayer or a disqualified person, as relinquished property.


Reverse Exchange Structures


There are two ways to structure your Reverse Exchange.


Exchange Last-EAT Holds Replacement Property


The “Exchange Last” structure is the most common form of reverse 1031 exchange. In the “Exchange Last” structure, you enter into a Qualified Exchange Accommodation Agreement with the Exchange Accommodation Titleholder. The EAT forms an LLC or other special purpose entity. You assign the EAT into the Purchase Contract for the replacement property.


You “loan” the EAT the money and/or arrange third-party financing for the acquisition of the replacement property. The EAT takes title to the replacement property. The EAT typically triple net leases the replacement property to you, as authorized by the Qualified Exchange Accommodation Agreement. The lease payments are offset by the loan payments you are owed by the EAT. The lease payments may cover any debt service owed on outside financing.


You identify your relinquished property 45 days after closing on your replacement property. You assign the Purchase-and-Sale Contract for your relinquished property to your Qualified Intermediary. When the relinquished property closes, you receive your replacement property or an LLC that holds title to the replacement property from the EAT by completing a simultaneous exchange. The EAT uses the proceeds from the relinquished property to pay down the loan to a third-party lender and/or to you.


If you need to secure institutional financing, you should obtain lender approval before entering into an “Exchange Last” structure. Since the EAT holds the Qualified Indicia of Ownership, it will have to be the borrower on the loan. The EAT typically signs a non-recourse loan and deed of trust in the event that the taxpayer defaults on its obligations and the taxpayer is allowed to guarantee the loan on a recourse basis.


Reverse / Improvement Exchange


The “Exchange Last” structure may be employed in a Reverse / Improvement Exchange. In this type of exchange, you build a new replacement property or improve an existing one before selling your relinquished property.


When to Use Exchange Last Parking


Taxpayers typically employ the “Exchange Last” structure when they are purchasing the replacement property for cash or the seller is providing short-term financing.


Issues with an Exchange Last Structure


Cash Boot Potential: If the amount of the down payment (which is the money loaned to the EAT) used to acquire the replacement property is less than the equity generated from the sale of the relinquished property, you could be liable for taxable boot.


(Note: To qualify for 100% tax deferral in a 1031 exchange, the equity in the replacement property must be equal to or greater than the equity in the relinquished property.) If the equity from the relinquished property is more than the down payment on the replacement property, the EAT can contribute additional cash to avoid a tax liability.


Financing: If seller financing is not available, then you must pay cash for the replacement property or arrange institutional or other financing. Obtaining outside financing is often difficult. If outside financing is available, the EAT will be required to execute a non-recourse loan guaranteed by you. When you take title to the replacement property, you must assume any outstanding loan balances.


Exchange First Structure-EAT Holds Relinquished Property


In the case of a parked relinquished property, you complete a simultaneous exchange by “selling” (transferring) your relinquished property to the EAT and acquiring your replacement property. The relinquished property may not be transferred to a disqualified entity. When you find a buyer for the relinquished property, the EAT direct deeds the property to the buyer and transfers any net sales proceeds to you.


In the “Exchange First” structure, you assign a Purchase-and-Sale Contract for the relinquished property to the Qualified Intermediary. You enter into a Qualified Exchange Accommodation Agreement with the EAT. The EAT sets up an LLC or other special purpose entity to take title to the relinquished property. You “sell” the relinquished property to the EAT. You and/or your lender loan money to the EAT and the EAT gives your lender and/or you a note(s) secured by a mortgage. The EAT uses your “loan” to acquire the relinquished property from the Qualified Intermediary. The Qualified Intermediary uses the funds from the EAT (your “loan”) to purchase the replacement property on your behalf. The replacement property is direct deeded to you and the exchange is completed. Once a buyer for the relinquished property is found, the proceeds from the sale of the relinquished property are used to satisfy any notes given by an outside lender or you.


When to Use Exchange First Parking Structure


An “Exchange First” may be a more viable option than an “Exchange Last” when you need to obtain conventional financing on the replacement property. Lenders may have difficulty lending on a property that is held by an EAT.


Issues with “Exchange First” Structures


Cash Boot Potential: If the equity in the relinquished property is greater than the cash invested in the replacement property, then you may incur capital gain tax liability. Since you have already purchased your replacement property, you will not have the opportunity to balance your exchange. For this reason, having the EAT hold the replacement property (“Exchange Last”) may be a more desirable option than the “Exchange First” structure.


Relinquished Property Loan: By transferring your relinquished property to the EAT, you risk triggering the due-on-sale clause in your relinquished property loan. This is one of the reasons that many EATs will not hold qualified indicia of ownership to the relinquished property.


Choosing the Relinquished Property: It may be difficult for you to determine which relinquished property is most suitable for your Reverse Exchange.


Pre-Exchange Due Diligence


Before setting up your exchange, the EAT will require you to submit the following:


1) Financial statement or tax returns for the last two years;
2) Grant deed for the relinquished property;
3) Binder providing proof of property, casualty and liability insurance and naming the LLC as the insured and the EAT and taxpayer as additional insureds;
4) Phase I Environmental assessment report issued within the last 6 months; the report must indicate that the property is free of contamination and be certified to the EAT (commercial and industrial real property and vacant land); and
5) Title insurance binder naming the EAT as the insured (real property).


Issues with Reverse §1031 Exchanges


The costs surrounding reverse 1031 exchanges are considerably more substantial than those for a traditional, rorward delayed exchange.


Fees for reverse 1031 exchanges are higher than fees for forward, delayed exchanges due to documentation and the risk the EAT assumes by taking title to the “parked” property. You will also incur additional title insurance, environmental, loan, legal, property, casualty and liability insurance, and escrow/closing costs.


The potential of incurring double taxation of state, county or local transfer taxes when a property is transferred to the EAT and then transferred to the buyer (“Exchange First”) or to the taxpayer (“Exchange Last”) initially caused concern among investors and their advisors. However, in a recent Private Letter Ruling (PLR 200148042), the Internal Revenue Service approved an express declaration of agency for all purposes except
federal income tax purposes in an EAT’s Qualified Exchange Accommodation Agreement. Transferring property from an agent to a principal is not a taxable event in most jurisdictions. While a Private Letter Ruling only pertains to a ruling on one particular case, this nonetheless provides insight into the Internal Revenue’s views on the subject.

Depreciation: The ability to depreciate the property is unavailable until you acquire title to the replacement property or once you have transferred the relinquished property to the EAT.


Alternative Strategies


After reviewing the costs involved in a Reverse 1031 Exchange, you may want to find a way to delay the closing of the replacement property until you find a buyer for your relinquished property and can completed a Forward Exchange.


Solutions that allow you to secure your replacement property include using conditional or non-refundable earnest money or an option or lease/option agreement.


Reverse 1031 exchange structures are extremely complex transactions. Taxpayers should always consult with competent tax and legal advisors that are familiar with 1031 tax-deferred exchange transactions before entering into a reverse 1031 exchange transaction.