Understanding the Reverse Exchange Process
In a standard “forward” or “deferred” 1031 exchange, a taxpayer defers capital gains taxes by exchanging property (“relinquished property”) for like-kind property of equal or greater value (“replacement property”) and reinvesting all of the net proceeds. While the replacement property doesn’t have to close escrow until 180 days after the sale of the relinquished property, the replacement property itself must be identified within 45 days after the sale closes. This creates a very difficult scenario for taxpayers who are concerned about locating viable replacement properties in a timely fashion.
In light of the foregoing, many taxpayers prefer to first find a replacement property and acquire that property before they sell their relinquished property. Fortunately, a taxpayer can still obtain the benefits of section 1031 by utilizing what is referred to as a reverse exchange under Revenue Procedure 2000-37.
There are two ways in which a reverse exchange can be structured. In an “Exchange First” transaction, the Qualified Intermediary (“QI”) utilizes an exchange accommodation titleholder (“EAT”) to purchase the relinquished property so the taxpayer can take direct title to the Replacement Property. Alternatively, an “Exchange Last” transaction can be structured where the EAT directly purchases the replacement property and retains title until the taxpayer sells the relinquished property. Most reputable exchange companies will only hold title to either property under a separate LLC that is created solely for this purpose.
How the Exchange First Process Works
The taxpayer loans funds to the EAT to purchase the relinquished property. The purchase price is estimated by the taxpayer or is based upon a pending purchase agreement. The QI acts as the seller, receives the proceeds and then uses those funds to acquire the replacement property on the taxpayer’s behalf. At this point, the taxpayer has completed the exchange of the relinquished property for the replacement property, but the EAT remains on title to the relinquished property until it has been sold.
For a successful completion of the reverse exchange, the EAT must complete the sale of the relinquished property within 180 days from the date the EAT acquires the relinquished property. It is however, the taxpayers’ responsibility to locate a buyer and negotiate the terms of sale between the buyer and the EAT. When the sale closes, the proceeds are used to repay the loan the EAT originally obtained from the taxpayer to first acquire the relinquished property.
How the Exchange Last Process Works
The taxpayer loans funds to the EAT to purchase the replacement property. The EAT purchases the replacement property and holds title until the taxpayer finds a buyer for the relinquished property, and is ready to complete the exchange. After the taxpayer locates a buyer, the QI sells the relinquished property on the taxpayer’s behalf, receives the proceeds and then uses the proceeds to acquire the replacement property from the EAT. The QI then instructs the EAT to convey title directly to the taxpayer. The EAT uses those proceeds to repay the loan it originally obtained from the taxpayer to acquire the replacement property. The taxpayer has 180 days to sell the relinquished property and acquire the replacement property from the EAT, which commences on the date the EAT acquires the replacement property.
The reverse exchange therefore represents a valuable tool for those taxpayers who must complete the acquisition of their replacement property before they can sell their relinquished property. Reverse exchanges are a valuable tool, but remember to consult with your tax adviser or attorney as part of your evaluation. Contact us for any of your 1031 exchange needs or questions.