Safe Harbor Reverse 1031 Exchange
In a reverse exchange, the investor is able to close on the acquisition of the replacement property before the relinquished property is sold to a third party buyer. This is done by temporarily “parking” either the replacement property or the relinquished property with a third party “accommodator.” In each case, First American Exchange acts as the qualified intermediary and also creates a limited liability company that temporarily takes title to the property.
SAFE HARBOR RULES
All of First American’s reverse exchanges are done in accordance with the IRS’s safe harbor rules of Revenue Procedure 2000-37, which means that the entire transaction must be completed within 180 days of the first closing. Under the safe harbor rules, the entity that takes title to the parked property is called an “exchange accommodation titleholder” or “EAT.” The benefit of the safe harbor is that the EAT can be considered the owner of the parked property for tax purposes, even though the EAT does not receive any income from the property or pay any expenses of the property.
The two types of reverse exchanges are referred to as the “exchange last” and the “exchange first” reverse exchange.
In an “Exchange Last” reverse exchange, the EAT takes title to the replacement property at the scheduled closing by borrowing funds from the investor and signing any third party loan documents. The investor has full control over the property, is required to pay all expenses of the property and has all rights to receive the income from the property. Once the relinquished property is ready to be sold to the third party buyer, First American as the qualified intermediary sells the relinquished property to the buyer and uses the funds to acquire the replacement property from the EAT.
In an “Exchange First” reverse exchange, the EAT takes title to the relinquished property. This must happen prior to the closing of the replacement property. The EAT pays the purchase price by taking the property subject to any existing financing and borrowing the equity from the investor. The EAT uses the borrowed funds to pay for the relinquished property and they become exchange funds. First American Exchange uses those exchange funds to acquire the replacement property.
As with an exchange last transaction, the investor has full control over the relinquished property, is required to pay all expenses of the relinquished property and retains all rights to receive the income from the relinquished property.
In order for an exchange first reverse exchange to work, the investor must arrange for a third party buyer to acquire the relinquished property and that sale must close within 180 days after the date that the EAT takes title to it.
BENEFITS AND DRAWBACKS
Some investors prefer to locate the replacement property before putting the relinquished property on the market. This strategy can be beneficial because it allows investors time to locate their desired replacement property without the pressure of the 45-day identification period, and provides additional time to list and sell the relinquished property which may mean an increase in the sale price. A reverse exchange structure can also afford the investor the opportunity to complete improvements on the replacement property prior to giving up the relinquished property which is often essential when relocating a business.
Reverse exchanges do take a little more planning and cost slightly more than a typical forward exchange and it is best to get First American Exchange involved early in the process to discuss the details. Under the right circumstances, a reverse exchange can be well worth the time and expense to preserve the tax-deferral treatment under section 1031. Reverse exchanges truly help make the impossible possible.