With the real estate market improving and the recent tax changes in place in 2013, more and more investors are considering a §1031 exchange. The §1031 tax-deferred exchange is a powerful tool that gives real estate investors the opportunity to sell investment property (relinquished property) and acquire new investment property (replacement property) while deferring tax on the gain. A tax-deferred exchange allows an investor 45 days to identify the replacement property after transferring the relinquished property and up to 180 days to acquire the new property. Both properties must be held for investment and in order to defer all taxes, property must be acquired that is equal or greater in both value and equity.
WHY A REVERSE EXCHANGE?
A reverse exchange occurs when an investor wants to acquire replacement property prior to the closing of the relinquished property. This can occur because the relinquished property sale has fallen through, there is limited real estate inventory available, or because the investor has found the perfect replacement property before being able to sell the relinquished property. In any case, the investor can save the exchange by completing a “reverse” exchange.
Although called a “reverse exchange,” the investor does not actually acquire the replacement property. A third party accommodator referred to as an EAT (Exchange Accommodation Titleholder) temporarily takes title to or “parks” either the relinquished or the replacement property.
HOW DOES A REVERSE EXCHANGE WORK?
In a reverse exchange, the EAT acquires title to either the replacement property (“exchange last transaction”) or the relinquished property (“exchange first transaction”).
It is important to note that a reverse exchange must be set up and structured with an EAT prior to the replacement property closing.
EXCHANGE LAST TRANSACTION
In an exchange last transaction, the EAT acquires title to the replacement property at the scheduled closing. The acquisition is funded by the taxpayer or by a loan arranged by the taxpayer.
The EAT leases the replacement property to the taxpayer. The lease provides that the taxpayer receives all of the income and pays all of the expenses of the replacement property.
Once a third-party buyer is found for the relinquished property, the relinquished property is transferred to the buyer as the first leg of a forward exchange, and the EAT acquisition loans are repaid from the available proceeds.
After the relinquished property has been transferred to the buyer, the replacement property is transferred to the taxpayer as well as any net sale proceeds from the relinquished property, which completes the reverse exchange.
EXCHANGE FIRST TRANSACTION
In an exchange first transaction, the EAT acquires title to the relinquished property prior to the scheduled closing of the replacement property, as the first leg of a forward exchange.
The EAT leases the relinquished property to the taxpayer, The lease provides that the taxpayer receives all of the income and pays all of the expenses of the relinquished property.
On the scheduled closing date, the taxpayer takes title to the replacement property to complete the forward exchange.
Once a third-party buyer is found for the relinquished property, the relinquished property is transferred to the buyer and any net sale proceeds from the relinquished property are used to retire any debt, or portion thereof, incurred by the EAT on its acquisition of the relinquished property.
Reverse exchanges under the IRS safe harbor rules of Revenue Procedure 2000-37 must be completed within 180 days.
In an exchange last transaction, the investor has 45 days from the first closing to identify the relinquished property.
Most rules that apply to 1031 tax-deferred exchanges also apply to reverse exchanges.
All of these transactions must be set up as an exchange, rather than as a sale followed by a purchase.
Reverse exchange transactions are more costly and require more planning than a typical forward exchange. This article is a very brief overview of the reverse exchange procedure. It is best to consult with your accountant or attorney and get the EAT involved early in the process to discuss all of the details, as well as the benefits and drawbacks. Under the right circumstances a reverse exchange is well worth the time and expense to preserve the tax deferral treatment under section 1031.
Reprinted with permission
First American Exchange Company ™