Church

A familiar comment among realtors, investors and attorneys is, “We hear about reverse exchanges, but does anyone really do them?” The answer is an emphatic “Yes!” Although reverse exchanges comprise a small fraction of the total like-kind exchanges undertaken annually, reverse exchanges are accomplished every day. While they are not for everyone, reverse exchanges can be a valuable tax-deferral tool for a savvy investor or business owner.

The more typical real estate exchange is a “forward” exchange in which an exchanger’s relinquished property is sold and the net proceeds of sale are paid to a qualified intermediary, which subsequently completes the exchange by purchasing replacement property with those sale proceeds. A reverse exchange involves the opposite scenario — the replacement property is acquired prior to the sale of the relinquished property. Grounded in Internal Revenue Code 1031, both types of exchanges allow a taxpayer to defer capital gains and other taxes occasioned by the sale and replacement purchase of business use or investment property.

Who Does Reverse Exchanges?

Baker

Seller’s Market. In a seller’s market, purchasers must act quickly to claim prime properties, and sellers are unwilling to delay closing until the taxpayer has sold his relinquished property. The investor must purchase the replacement property though a reverse exchange or lose the opportunity.

Sellers of Multiple Properties. Consider the exchanger who has $2 million of relinquished properties on the market. The exchanger has sold the first of these properties for $750,000 when a $2.5 million replacement property becomes available for immediate purchase. A reverse exchange allows the exchanger to park this replacement property until additional relinquished properties have been sold, thereby maximizing the benefit of the exchange.

Warehousing. REITs and other multiple-asset investors use reverse exchanges to “warehouse” replacement properties to be matched with planned or unplanned future sales. The investor will acquire replacement properties in reverse exchanges to preserve the right to match these new properties in the event that any of its relinquished properties are sold within the 180-day exchange period.

Build-to-Suit. Exchangers, who need to have improvements built on replacement property prior to taking title and completing the exchange, find the reverse exchange to be invaluable. The “safe harbor” allows the exchanger to manage the construction. Having the title held by an Exchange Accommodation Titleholder (EAT) is far less risky than having construction performed while the seller is still in title.

While an excellent tool, reverse exchanges are not for every taxpayer or every situation. Despite the many tax-planning advantages of reverse exchanges, they are not as simple or inexpensive as the typical forward like-kind exchange.

Requirements & Challenges

The guidelines for reverse exchanges are found in Revenue Procedure 2000-37, which introduces the concept of the EAT. The EAT is analogous to the qualified intermediary (QI) in a forward exchange with one major difference. Unlike a QI, which is not required and typically refuses to take title, the EAT must hold “qualified indicia of ownership” to either the relinquished property being sold by the exchanger or the replacement property being acquired. This usually takes the form of legal title, but could also be ownership of a disregarded entity that owns the property, such as a single member LLC. This is referred to as “parking” since the taxpayer is “parking” title temporarily with the EAT.

In order to receive the “safe harbor” protection of Rev. Proc. 2000-37, the EAT and the exchanger must enter into a “Qualified Exchange Accommodation Agreement” within 5 days of the EAT taking ownership of the parked property. Although the EAT must be the owner of the parked property for federal income tax purposes, the other customary benefits and burdens of ownership, such as possession and control, may contractually remain with the taxpayer through the use of triple-net leases or management agreements.

The identification and holding time deadlines mirror those in forward exchanges, with a requirement that the taxpayer identify any potential relinquished properties within 45 days after the EAT acquires the parked property. Likewise, the exchange must be completed and title transferred from the EAT to the exchanger within 180 days.

One of the challenges facing taxpayers attempting reverse exchanges is financing. Although the EAT must take title, it will not hold an equity interest. Because the exchanger does not have access to the equity contained in the unsold relinquished property, he must have sufficient resources or a willing lender that will provide necessary financing to the EAT. Prudent EATs will insist that all loans be entirely non-recourse to the EAT to minimize exposing their clients’ properties to claims of other creditors. Significant resources of time and money can be expended by the EAT and exchanger to educate a lender unfamiliar with reverse exchanges and make it comfortable with non-recourse financing to the EAT, backed by the personal guarantee of the exchanger.

Economic Impact

Exchangers must also evaluate the economic consequences of a reverse exchange. A triple-net lease is frequently used to shift the economic burdens and benefits of the parked property from the EAT to the exchanger. This allows the exchanger to receive all rental income produced by the parked property and relieves the EAT from real estate taxes, debt service and maintenance obligations. Although the exchanger receives the economic benefits of the parked property, the EAT is the owner for federal (and sometimes state) income tax purposes. As a result, the exchanger cannot claim depreciation for the parked property during the time it is owned by the EAT. The cost of lost depreciation over a potential 6-month period should be balanced against the benefit of the tax deferral.

Because the EAT holds title, its risk is quite different from that of the QI. Typical EAT requirements are up-to-date environmental reports for the parked property, general liability and property insurance naming the EAT as an additional insured and broad indemnities from the taxpayer.

Since the skill level demanded of EATs and potential liability is greater, reverse exchange fees are substantially higher than forward exchanges. Fees can range from $5,000 to tens of thousands of dollars depending on the value of the properties being parked and liability factors.

Usually the fees paid to the EAT are a small portion of the total expenses of a reverse exchange. Consulting, legal and accounting fees will also be greater due to increased complexity. Lenders also tend to charge a premium for participating in a reverse exchange. Because reverse exchanges involve a double transfer of the parked property (once to the EAT and once from the EAT), there may be double transaction expenses such as transfer taxes, settlement agent fees and title insurance. In some cases, these additional expenses can be limited or avoided, but taxpayers exploring the option of a reverse exchange should be aware of the potential expenses.

Careful EAT Selection

The exchanger also has greater risk in a reverse exchange because the EAT holds title to the exchanger’s property. The EAT field is unregulated, so anyone, regardless of background and stability, can claim to be an EAT. Prudent exchangers should take care when selecting an EAT. Many individuals, such as agents, related parties and the exchanger’s attorney, accountant and real estate broker are disqualified from acting in this capacity. Moreover, an institutional EAT can protect this very time-sensitive transaction from problems arising from bankruptcy, death, disability or other ill-timed legal difficulties to which individuals are prone.

Financial strength and stability should be considered. The exchanger should be comfortable that its parked property will be protected from claims relating to the EAT’s own difficulties or that of its other clients. For this reason, best practices dictate segregation of all properties held by the EAT into separate LLCs for each exchange.

The EAT should provide documents for the various steps required to complete the exchange, and it should have a knowledgeable staff to assist exchangers and their tax advisors through the complicated web of requirements of Sec. 1031 and the relevant Treasury Regulations and Revenue Procedures. A first-rate EAT should also be able to act with a sense of urgency and flexibility inherent in transactional business, notwithstanding that structuring and documenting a reverse exchange is significantly more complicated and time-consuming than a simple forward exchange.

Although reverse exchanges are not the first choice in a 1031 like-kind exchange, they provide tremendous flexibility. Reverse exchanges are the only way to capture tax deferral benefits when the relinquished property cannot be sold prior to the closing of the replacement property purchase or improvements need to be constructed on the replacement property prior to completion of the exchange.

Karin Church and Suzanne Goldstein Baker are vice presidents of Investment Property Exchange Services Inc. in Chicago.

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