Introduction to Reverse 1031 Exchanges
A Reverse 1031 Exchange transaction allows an Investor to sell their current relinquished property after purchasing their like-kind replacement property as per Revenue Procedure 2000-37. This practice is quite effective in markets where inequalities exist between the supply and demand aspects of the real estate market, especially when the Investor is compelled to buy their like-kind replacement property at the beginning of the transaction as opposed to the end. A Reverse 1031 Exchange may be idea if an Investor needs flexibility and is concerned about not being able to adhere to the deadlines imposed by a standard 1031 Exchange transaction, which is 45 calendar days of closing on the relinquished property.
Reverse 1031 Exchanges can be very complex, and it is recommended that an Investor always employ experienced advisors and Qualified Intermediaries in order to ensure that the transaction is completed correctly and that maximum income tax deferral is achieved.
The Investor needs to have the financial ability to purchase the replacement property. Remember, the Investor will not have the benefit of sale/exchange proceeds since the relinquished property has not yet been sold. The Investor must draw upon other financial resources for the acquisition. If a loan from a commercial lender is needed, then the lender has to be willing to lend the money to the EAT.
Parking refers to the Exchange Accommodation Titleholder (EAT) taking and holding title to the property during the exchange (“Warehouse”, “station”, “place” would also be apt descriptions, but the IRS uses “park” as its metaphor). This parking technique is used because Revenue Procedure 2000-37 prohibits the Investor from having ownership of the relinquished and replacement property simultaneously.
There are two parking approaches for completing a Reverse Exchange: park replacement property and park relinquished property. Deciding which property (either the replacement property or relinquished property) is parked is determined by considering a number of factors: the funding source to pay for the acquisition, liens on the relinquished property, and the equity in the relinquished property.
If the Investor wishes to improve the replacement property, then the replacement property must be parked. Any improvements are to be constructed prior to the Investor’s receipt of the replacement property.
No matter which property is parked, the property is available to the Investor. Equity Advantage creates a lease and property management agreement between the EAT and the Investor so that the Investor has complete access to the parked property.
The “Exchange Last” structure can be utilized in a Reverse improvement tax-deferred like-kind Exchange structure as well (sometimes referred to as build-to-suit or construction tax-deferred like-kind Exchange). In this type of tax-deferred like-kind Exchange, the Investor can build a new structure, improve an existing structure or retrofit the property before selling their relinquished property.
In the park relinquish approach, Equity Advantage creates a new single member, single asset LLC. Equity Advantage is the sole member of the LLC and the relinquished property will become its sole asset.
When the LLC acquires the replacement property, the LLC simultaneously swaps it with the Investor’s relinquished property. In effect, the LLC has transferred the replacement property to the Investor and the LLC has received title to the relinquished property. The relinquished property is owned by the LLC until a buyer is found. At the time of closing, title of the relinquished property will be transferred from the LLC to the buyer and the sale proceeds will go to Equity Advantage as they would in a delayed exchange. The sale proceeds are then used to payoff loans incurred by the LLC, completing the exchange.
A Reverse Exchange typically tends to be more costly than a normal 1031 Exchange, mostly due to the extra risk involved in such transactions, especially buy the EAT when acquiring, holding and “parking” legal title to the Investor’s relinquished or replacement property. There are also multiple insurance considerations on the part of the Investor and the possibility of double state, county or local taxes.
There are alternative strategies to a Reverse Exchange as well, including restructured the transaction into a forward 1031 Exchange by approaching the seller of the like-kind replacement property to see if the deal can be delayed until a buyer can be found for the relinquished property. There are monetary incentives that can encourage the seller to go along with this course of action, such as carrying back some financing in the short-term to assist the Investor with his Reverse 1031 Exchange transaction. In addition, there are numerous safe-harbor provisions for properly structuring Reverse 1031 Exchange transactions as noted by the Internal Revenue Service and Treasury Department.
There can be several issues with Exchange Last Parking Structure. The Investor may accidentally create cash boot and will recognize depreciation recapture and/or capital gain income tax liabilities if the amount of the down payment advanced by the Investor to the EAT used to acquire the like-kind replacement property is less than the equity generated from the sale of the relinquished property. Also, when an Investor takes title to the like-kind replacement property, they must assume any outstanding loan balances.
An Exchange First parking is when an Investor acquires and closes on the like-kind replacement property while at the same time that relinquished property is acquired, held or parked by the EAT and a simultaneous or concurrent tax-deferred like-kind Exchange transaction is completed. The EATsets up a single-member LLC or other special purpose entity to acquire, hold, or park title to the relinquished property. The Investor will then sell the relinquished property to the Exchange Accommodation Titleholder in order to complete the simultaneous tax-deferred like-kind Exchange transaction. Once the relinquished property is sold, the profits from the sale are used to pay off any financing obtained to complete the Exchange.
Deadlines for Identifying relinquished property and transferring parked property are as follows (NOTE: these deadlines cannot be extended for any reason whatsoever, short of an order by the President of the United States):
- Time to identify the property intended to be relinquished or disposed of as part of Reverse Exchange transaction: 45 calendar days after the transfer
- Time to sell and transfer the relinquished property: 180 calendar days
Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.
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