By Michael S. Brady, Esq., Vice President, Riverside 1031 LLC
Commercial property values are on the rise, and many property owners are looking reinvest their profits in assets that provide new opportunities.
Faced with federal, state and local capital gain tax rates approaching 30 percent or more, these investors are frequently turning to 1031 Exchanges to defer their taxes and keep their money working for them.
Problem: tight deadlines
However, the tight 1031 exchange deadlines create problems. From the closing of the Relinquished Property, an investor only has 45 days to identify the Replacement Properties they want to purchase and up to 180 days to close.
Our clients tell us it is difficult to find and close on deals that make sense in such a tight timeframes.
Solution: Reverse exchange
As a result, more investors are turning to the “Reverse Exchange”. While the typical 1031 Exchange involves the investor selling their Relinquished Property before closing on the purchase of their Replacement Property, it is possible to close on the Replacement Property first.
By locking up the Replacement Property before closing on the sale, the investor can remove much of the time crunch and uncertainty that they would typically face in a 1031 exchange.
However, in order to defer capital gain, IRC §1031 requires an “exchange” of property, so the investor may not own the Relinquished and Replacement Property at the same time.
As a result, while the Replacement Property can close before the Relinquished Property, the investor may not take title to it until after they have conveyed title to the Relinquished Property to a third party.
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 Qualified Intermediary company hired by the investor to facilitate the tax deferred exchange. This structure solves the dilemma the investor faced: by “parking” title to one of the properties with the EAT, the investor avoids owning both properties at the same time.
The structure of a typical Reverse Exchange transaction would be as follows:
- The investor finds the ideal Replacement. The parties go to contract;
- Prior to closing on the Replacement Property, the Qualified Intermediary sets up the EAT. The parties enter into a Qualified Exchange Accommodation Arrangement Agreement (“QEAA”), which may give the investor a call right with regard to the Replacement Property. The investor also assigns the contract of sale for the Replacement Property to the EAT. Prior to closing, the seller is given written notice of the 1031 exchange and the contract assignment;
- Both the investor and the institutional lenders loan the EAT the funds necessary to acquire the Replacement Property. The EAT will typically insist that the loan terms be non-recourse, but the investor is permitted to guaranty the loan;
- At closing, the seller deeds the property to the EAT. The EAT then leases the Replacement Property to the investor, so that the investor has use of it during the Exchange Period and bears the burden for all maintenance, repairs, utilities, and other property related costs;
- From the closing of the purchase, the investor has 45 days to identify the Relinquished Property they hope to sell, and a maximum of 180 days to close;
- The investor finds a purchaser for the Relinquished Property and enters into contract. The investors enters into an Exchange Agreement with the Qualified Intermediary, and assigns the benefits of the contract to the Qualified Intermediary. The purchaser is given written notice of the 1031 exchange and the contract assignment;
- At closing the investor deeds the Relinquished Property to the purchaser, and purchaser pays the net sale proceeds to the Qualified Intermediary.
- After the Relinquished Property closing, the investor assigns the “call” provision of the QEAA to the Qualified Intermediary, who then uses the sales proceeds to repay the funds the EAT borrowed from the investor. The EAT transfers the Replacement Property to the investor, either by deed, or more commonly, by transferring 100% of the membership interests in the EAT. This completes the reverse exchange.
This article describes a basic Reverse Exchange, but many factors may alter the structure. For instance, it may be preferable to park the Relinquished Property, rather than the Replacement Property, particularly if the lender isn’t comfortable providing a loan to the EAT.
In other cases, the investor may want to use the Exchange Funds to make improvements to the Replacement Property.
And if Replacement Property is less expensive than Relinquished Property, the investor may want to acquire additional Replacement Properties after the Relinquished Property has been sold.