Investors have the option of utilizing the "reverse" 1031 exchange method to defer taxes upon the sale and purchase of real estate. While the typical 1031 exchange involves the exchanger selling their relinquished property then purchasing a replacement property, in that order, it is possible to make an exchange work in the opposite order, commonly known as a reverse 1031 exchange.
In order to defer capital gains tax, IRC Section 1031 requires an exchange of property. The exchanger must acquire a new property as a replacement for the old property. The rules for exchanges do not allow the exchanger to exchange into property that the exchanger already owns. Thus, the exchanger cannot acquire the replacement property before selling the relinquished property. This rule can cause an issue when the exchanger is ready to purchase a new property and that closing is scheduled to occur before the exchanger's old property is sold. However, the tax rules allow for a reverse structure to work. The rules covering a reverse exchange call for an exchange company to hold title to one of the properties, usually the replacement property, until the exchanger has sold the relinquished property. The exchange company then conveys the replacement property to the exchanger once the relinquished property is sold. This allows the exchanger to avoid owning both properties at the same time, but still complete an exchange, in cases where the replacement property closing is scheduled to occur first.
Provisions for reverse exchanges were approved by the Internal Revenue Service in Revenue Procedure 2000-37. The approved structure involves a Qualified Exchange Accommodation Arrangement whereby an Exchange Accommodation Titleholder ("EAT") acquires legal title to either the replacement property or the relinquished property until the relinquished property can be sold to a third party. The EAT is usually a limited liability company that is owned by the exchange company hired by the exchanger to facilitate the tax deferred exchange.
The steps in a typical reverse exchange:
1. The exchanger finds a replacement property and that deal is ready to close, however, their relinquished property has not yet sold;
2. The exchanger contacts an exchange company. The exchanger hires the exchange company to act as the EAT in order to facilitate the reverse exchange by entering into a Qualified Exchange Accommodation Agreement ("QEAA"). The purchase contract for the replacement property is assigned to the exchange company as the buyer of that property;
3. The exchanger secures financing for the EAT to acquire the replacement property through a combination of the exchanger's own funds and/or an institutional lender such as a bank. The exchanger is permitted to guarantee the bank loan. Any funds provided by the exchanger directly is a loan to the EAT;
4. At closing, the replacement property seller deeds the property to the EAT and the EAT executes all loan documents. The EAT then leases the replacement property to the exchanger, so that the exchanger has use of it during the exchange period and bears the burden for all maintenance, repairs, utilities, and other property related costs;
5. Similar to a forward exchange, the exchanger has 45 days, from the closing of the purchase, to identify the relinquished property they hope to sell, and a maximum of 180 days to close on the sale of the relinquished property;
6. The exchanger finds a purchaser for the relinquished property. The exchanger then completes the exchange similar to any typical 1031 exchange using an exchange company and the typical exchange documentation. The relinquished property is sold to a third party and the exchanger acquires the replacement property, which is now being held by the EAT. The exchange company transfers the replacement property to the exchanger, either by deed, or more commonly, by transferring 100% of the membership interests in the LLC acting as EAT to the exchanger to complete the exchange;
7. The sale proceeds representing equity from the relinquished property sale are used to repay the exchanger and/or the institutional lender for the loan to the EAT. This is accomplished through the exchange company.
This outlines the typical reverse exchange transaction. There are many considerations that may alter the structure.
For instance, in certain circumstances, it may be preferable to park the relinquished property, rather than the replacement property, particularly if the bank/lender isn't comfortable providing a loan to the EAT.
In other cases, the exchanger may want to use funds from the relinquished property sale to make improvements to the replacement property while it is still owned by the EAT.
Additionally, if the replacement property purchase price is less than the relinquished property sale price, the exchanger may want to acquire additional replacement properties after the relinquished property has been sold.