Reverse Exchanges: A twist on 1031 exchanges helps make this tax-deferring investment strategy more viable

An alternate route
By: ROCHELLE STONE, JOHN MANGHAM: REALTOR® Magazine Online
Betty vacations at the beach each year. This year she decides to buy an investment property there. With the help of a real estate salesperson, she finds the perfect condo unit—at a below-market price of $400,000. Betty wants to use the proceeds from the sale of her rental house, another investment property, to buy the condo. To defer taxes on the capital gain, she plans to use a 1031 tax-deferred exchange. However, because of the hot beachfront market, Betty is afraid to wait to make an offer on the condo until she’s found a buyer for her property. To solve the timing problem without losing the deal, the salesperson suggests a reverse exchange.

A reverse exchange shares similar requirements with the more common deferred exchange. In a delayed exchange, once an exchanger has sold the property to be relinquished, the person must use a qualified third party (an intermediary) to receive the sales proceeds at closing and then use the money to acquire title to the replacement property.

However, in a reverse exchange, a second intermediary, called an accommodation titleholder, takes title to either the relinquished or the replacement property since the exchanger can’t hold title to both properties at once. The AT may remain as the owner for 180 days, allowing the exchanger time to locate a buyer for the property to be relinquished. Note: The two intermediaries in a reverse exchange can be the same person.

Like the more common delayed exchange, in which the property the exchanger owns is sold first, a reverse exchange allows exchangers to defer taxes completely if they use all net proceeds from the sale of a property to purchase a replacement property of equal or greater value.

There has been a significant increase in reverse exchanges since 2000, when the Internal Revenue Service issued Revenue Procedure 2000-37, which set guidelines for those transactions. In fact, some investors look for replacement properties before marketing property they intend to relinquish.

Reverse basics

Under IRS rules for reverse exchanges,

∙ Investors must use an AT to purchase and warehouse either the relinquished or the replacement property for up to 180 days.

∙ The AT can’t be the exchanger undertaking the exchange or a disqualified person, as defined by the Omnibus Budget Reconciliation Act of 1989. A disqualified person is anyone who has acted as the exchanger’s agent within the preceding two-year period, including an attorney, an accountant, an investment banker, or a real estate broker.

∙ The AT must be named on the title of either the replacement or the relinquished property.

∙ There must be a written qualification exchange accommodation agreement between the exchanger and the AT defining the intent and obligations of the parties and the restrictions on the proceeds by the exchanger.

∙ The exchange agreement must state that the AT will be treated as the beneficial owner of the warehoused property for federal tax purposes, including reporting interest and depreciation.

∙ The property to be exchanged must be identified in 45 days, and the transaction completed in 180 days, just as required for a delayed exchange.

∙ The exchanger may make and guarantee loans with the warehoused property as collateral, lease or manage the property being warehoused, or supervise construction or act as the contractor for improvements on the warehoused property before the exchange is final.

Structuring reverse exchanges

A reverse exchanger must have liquid financial resources to make the exchange viable. Reverse exchanges can be structured in two ways, depending on the exchanger’s resources and the financing available.

Option 1. The exchanger has sufficient funds to purchase the replacement property for cash, or the seller of the replacement property will take back financing. Under this option, the exchanger “lends” the AT the money to buy the replacement property. Once a buyer purchases the relinquished property, the intermediary uses the proceeds from the sale to acquire the replacement property from the AT and deed it back to the exchanger.

Option 2. When the exchanger doesn’t have the funds to purchase the new property for cash, the transaction must be structured differently. In this case, the exchanger must obtain cash from a line of credit or other source and then “lend” those funds to the AT so that the AT can purchase the relinquished property. The sale to the AT means there are proceeds the intermediary can use to purchase the replacement property.

The intermediary then deeds the replacement property to the exchanger, who can now use the property as collateral for the new mortgage loan. The subsequent sale of the relinquished property by the AT provides the funds to pay back the exchanger’s loan to the AT.

Although reverse exchanges are complicated and require financial strength, real estate practitioners and their investor clients would be well served to add this powerful financial tool to their portfolio.

Stone is the president and founder, and Mangham, CPA, is the southwest regional manager of Starker Services Inc., a national company that performs all types of 1031 tax-deferred exchanges. You can reach the authors at rstone@starker.com or 800/332-1031.