FEATURE ARTICLE, JANUARY 2006

GROWING IN REVERSE
Flexibility is a key reason why more commercial real estate investors are choosing 1031 reverse exchanges.
Rosa Esqueda

For real estate investors, finding a suitable investment property to purchase in a high-demand market is challenging, a process often requiring countless hours of research and a lot of money. If a 1031 exchange is involved, matters become more complicated because investors must complete transactions within a set timeframe, not only selling their investment property before purchasing new property, but also identifying their purchase within 45 days of the sale and closing the purchase within 180 days. In such a tight market, the pressure of meeting the 1031 exchange deadlines increases the risk of investors having to pay capital gains tax on the sale. However, more investors are realizing the reverse exchange will reduce the risk imposed by market conditions and 1031 exchange time constraints.

These issues are not new to the IRS. Noting that investors may have difficulty completing a deferred exchange, the Department of Treasury on September 15, 2000 published Rev. Proc. 2000-37, which provides safe-harbor guidelines that, if followed properly, allow investors to purchase a replacement property prior to selling their relinquished property. This is accomplished when the investor arranges for an Exchange Accommodation Titleholder (EAT) to take title to (“park”) either the sale (“exchange-first” reverse exchange) or the purchase (“exchange-last” reverse exchange). Ideally, the taxpayer will have sufficient funds to loan the EAT to acquire the replacement property. In return for the funds loaned, the investor will receive a note from the EAT. When the relinquished property is sold within 180 days of the EAT taking title, the EAT transfers either the parked relinquished property to a third party buyer or transfers the parked replacement property to the investor. As a final step, the EAT pays off the note issued to the investor.

A demanding market is not the only reason an investor would consider entering into a reverse exchange. Other motivations behind an investor preferring the reverse exchange structure over the deferred exchange include the failure of the buyer to meet contingencies on the sale before the purchase closes, the market where the sale is located is unable to produce a buyer, the cost of extending the contract on the replacement property exceeds the cost of structuring a reverse exchange, the earnest money deposit may be lost if the purchase does not close on time or the seller has not decided which properties to sell.

Natural disasters, like Hurricane Katrina and Hurricane Rita, may also be contributing to the increased number of reverse exchanges. There are situations when an investor may decide to purchase the replacement property now, but in the meantime repair damaged property located in the affected area before selling to a third party buyer. Conversely, an investor may want to seize the opportunity to purchase and repair the damaged investment property before selling the relinquished property. In this scenario, called a reverse “build-to-suit” exchange, the EAT would acquire the replacement property and construct improvements according to the investor's specifications. Meanwhile, the investor would have the time to select which relinquished property he or she would want to sell. Finally, after the improvements are made or after 180 days have passed from the EAT taking title, the EAT would transfer the improved replacement property to the investor.

Nevertheless, the flexibility that the reverse exchange provides investors may be the biggest reason they have become so popular. For example, an owner of four single-family rentals located in California planned to exchange the rentals for one large apartment complex in Arizona. All four rentals were scheduled to close 1 month prior to purchasing the apartment complex. However, a buyer for one of the rentals backed out suddenly and the owner could not extend the closing date for the complex. Instead of losing the ability to apply the equity from the sale of the fourth rental toward the purchase of the complex, the owner decided to structure both a straight deferred and reverse exchange. For the deferred portion, the owner sold the three rentals first and then acquired a three-fourths interest in the apartment complex. As for the reverse portion, an EAT took title to the remaining one-fourth interest in the apartment complex. Thereafter, the owner had 45 days to identify the fourth rental she wanted to sell and 180 days to convey the rental to a third-party buyer and receive the remaining one-fourth interest from the EAT.

While investors are realizing now, more than ever, the advantages of performing a reverse exchange, they must take caution to use them only as an alternative to the straight deferred exchange. Reverse exchanges are, by far, more complex, involve greater costs and require compliance with additional regulations. For instance, financing the purchase of the parked property by the EAT is one obstacle investors face. Whereas in a deferred exchange the exchange proceeds from the sale are used to finance the purchase, reverse-exchange investors must supply their own cash or find a third-party lender willing to loan money to the EAT. Investors find that many commercial lenders are uncomfortable financing the purchase of the parked property because, unlike straight deferred exchanges, the EAT must actually enter into the chain of title. In addition, most EATs require that any third-party lender financing be non-recourse to the EAT and fully assumable, without penalty, to the investor. Yet, as reverse exchanges become more common, savvy commercial lenders are finding innovative ways to meet investors' goals.

Moreover, investors should be aware that the costs associated with reverse exchanges are significantly greater than the transaction costs in a straight deferred exchange. Costs may include double-transfer taxes and closing costs or additional/higher fees charged by brokers, title insurance agents, escrow, qualified intermediaries, attorneys and/or accountants. Also, additional requirements may be imposed, such as casualty and hazard insurance and Phase I environmental reports, for commercial properties to be parked. Despite these concerns, investors are steaming ahead, or rather in reverse, with their 1031 exchanges.  

Rosa Esqueda is vice president and west region manager for LandAmerica 1031 Exchange Services in Los Angeles.


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