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The Optimal Exchange Strategy

In many situations, an Exchangor’s circumstances dictate which type of 1031 exchange should be used. For example, if there is a desirable Buyer for an Old Property who says that the close of the sale must occur at a certain time, then a delayed exchange is indicated. Likewise, if an Exchangor finds a desirable New Property and needs to close its purchase soon in order to secure the deal, a reverse exchange is indicated. Other constraints involve the issue of financing. For example, if an Exchangor simply cannot acquire a New Property prior to the sale of the Old Property, with the resulting availability of the cash proceeds, then a delayed exchange is the only option. At times, the need to keep the Old Property in place until the New Property is fully available will dictate the choice of strategy. In these situations, the Exchangors options are limited and it is relatively easy to determine the optimal course of action.

However, the Exchangor frequently has a choice of which strategy – delayed or reverse - to use. As shown below, there are many situations where a reverse is indicated. The frequency with which this is true is often quite surprising as the educational efforts of the QI industry over the last decade have focused tightly on delayed exchanges and, unfortunately, the optimal strategy for the Exchangor has often taken a back seat to the profit model of the QI.

Determining the optimal exchange strategy involves evaluating the primary criteria listed below. The relative importance of the criteria will be determined by the facts and circumstances of a particular situation. Each Exchangor should evaluate these at a level of detail that is appropriate to their objectives, particular risk sensitivities and economic situation.

Optimizing Return on Investment

An optimal exchange strategy delivers the best Return on Investment (“ROI”) to the Exchangor. Delayed exchanges involve the liquidation of the Old Property and entrusting the resulting cash proceeds to a QI. QIs earn interest on the exchange proceeds they hold. For many years, this has been the primary means that QIs use to generate revenue. In today’s interest rate climate, exchange proceeds seldom earn more than 0.75%, probably a lot less, and QIs typically share very little, if any, of these earnings with the Exchangor. Therefore, earnings on the exchange proceeds that inure to the Exchangor (i.e. ROI) during the exchange period will be modest at best and probably zero. In general, assets held for income or appreciation are usually providing income or increasing in value. Hence, to sell such an asset prematurely means that that stream of income or appreciation is stopped when the asset is sold. When lost income and/or appreciation are computed and factored into the overall economics of the exchange, a reverse exchange strategy frequently provides significantly more ROI to the Exchangor. In a delayed exchange, virtually all of the ROI goes to the QI. After all, if holding cash were a better investment, nobody would own investment assets.

An example of such a calculation is available here. A spreadsheet showing the details of the example is available by clicking here. The spreadsheet is in Excel and can be downloaded. You are free to modify the formulas, if you choose, and enter your own particular numbers to determine which exchange option offers the best economics. Use this spreadsheet at your own risk!! We assume no responsibility for its applicability to your situation, its accuracy or for the consequences of a decision you make or don’t make based on your use of the spreadsheet.

Optimizing Tax Deferral Potential

The potential to defer capital gains tax on the sale of Old Property is often the same if either a reverse or a delayed exchange is used. However, in many situations, typically those that are more complex, the ability to optimize tax deferral potential is greater when a reverse exchange is used. In cases where there are significant improvements that can be made to a New Property, an improvement exchange can increase deferral potential. In cases where there are multiple New or Old Properties involved, a hybrid exchange may increase deferral potential by providing more time to complete the strategy. And, in those cases where 180 days are simply not enough time to accomplish what is need, a non-safe-harbor reverse may provide the means to obtain and otherwise impossible deferment of taxes. All of these strategies provide tools and flexibility that are simply not available with standard delayed exchanges.

Managing Deadlines - Reducing the Risk of a Failed Exchange

In a delayed exchange, the Exchangor has 45 days to identify candidate New Property and 180 days to acquire it from among those properly identified. If no 45-day identification takes place, the QI is required by law to return the Exchangor’s cash and the exchange fails, resulting in no deferral of the tax on the gains resulting from the Old Property sale. If the 45-day identification does occur but the Exchangor realizes that the exchange is going to fail (if the identified property is sold to somebody else, for example), the QI is required by law to hold the Exchangors cash for the full 180 days before it can be returned. These restrictions are statutory and there is no flexibility regarding their application. In the current real estate market, for example, finding desirable New Property, getting the necessary credit arrangements in place and closing acquisitions have become significantly more difficult in the last few years and the risk of a failed delayed exchange has increased accordingly.

By contrast, a reverse exchange starts when the New Property is acquired. The Exchangor then has 45 days to identify potential Old Property to be sold. It is important to appreciate this difference: identifying potential New Property (in a delayed exchange) may result in far more risk of exchange failure due to increased risk of not being able to acquire what has been identified. In a reverse, the Exchangor is required to make a 45-day identification using assets it already owns and therefore has more chance of successful completion of the exchange due to the ability to influence the sale of Old Property.

Furthermore, if a reverse exchange is in danger of failing because the Old Property cannot be sold in time, the possible outcomes are generally more attractive. First, the Exchangor may simply elect to let the reverse exchange fail and end up owning both the New Property and the Old Property. This may place some stress on the financials of the Exchangor but the Old Property can, hopefully, be included in another exchange at a later time. The benefit of this approach is that there is no capital gain tax to defer since no sale of the Old Property has occurred! Secondly, the Exchangor may have the option to “extend” the exchange using a process that involves non-safe-harbor structures to complete the reverse exchange while providing more time to sell the Old Property. The cost and complexity of this approach have to be carefully evaluated and compared to the tax problem at hand. It is, however, an option that simply does not exist with delayed exchanges. See our section on Extensibility for more.

Optimizing Asset Utilization

An optimal exchange strategy provides the most effective asset utilization to the Exchangor. Asset utilization means making assets available for productive use and it means effectively positioning assets for involvement in an optimal exchange strategy.

For some types of assets, it does not make sense to sell the Old Property – thereby making it unavailable to the Exchangor – if there will be any substantive delay in acquiring the New Property. The classic examples here involve personal property assets such as aircraft. If a company has an airplane used to provide flexible, quick and convenient transportation to its senior executives, it makes no sense to sell the old aircraft before acquiring the new aircraft because the executive would have to fly commercial, like the rest of us! Similarly, heavy equipment and vehicles like rail cars or tractor/trailer combinations are usually in productive service and to take them out of service without having replacements is likely to be a poor approach to asset management.

If a delayed exchange is used, the Exchangor is required to identify replacement assets in 45 days and acquire from among those identified within 180 days. In many situations, being able to predict the assets that will be required – requirements driven by business opportunities – is very difficult. Furthermore, knowing the availability of assets with timing that conforms to the exchange deadlines is also uncertain. For example, if the Exchangor is a user of heavy equipment and buys from dealers or at auction in response to a combination of project requirements and good deals on required equipment, it may be very difficult, using a delayed exchange, to have new equipment acquired this way included in an exchange that has already started. Using a reverse exchange strategy, new equipment acquisitions start new exchanges with timing that is driven by the need for the new equipment. The 45-day identification requirements are met using Old Assets, assets which are already owned by the Exchangor. The required sale can then be timed to keep the equipment deployed productively as long as possible and controlled by adjusting sale terms.

Optimizing asset utilization results in improved ROI and fewer failed exchanges.

Improving Asset Security

In every 1031 exchange, whether deferred or reverse, the Exchangor entrusts valuable assets to their QI or Accommodator. In the case of a deferred exchange, the cash proceeds from the sale of the Old Property are held by the QI until the purchase of a New Property is closed. In the case of a reverse exchange, the Accommodator holds legal title to either the Old or the New Property, depending on the form of the reverse exchange.

The current state-of-the-art for deferred exchanges involves the use of a Qualified Escrow or Qualified Trust account. This structure is currently required in a number of states. These accounts are governed by three-party agreements involving the QI, the Exchangor and the Bank holding the funds. The role of the Bank is to authenticate each movement of funds by confirming the request (amount, destination) with the Exchangor. This type of depository arrangement has proven to be superior to the use of fidelity bonds (in the case of theft) and would also preclude the QI making unwise and unapproved investments with the cash. The state-of-the-art for reverse exchanges, when fully implemented as described below, also provides an elevated level of asset security because:

  • EAT Isolation. Each LLC or other SPE formed should generally be new and dedicated to the exchange for which it was formed. EATs should never be recycled and, at the conclusion of an exchange, should either be assigned to the Exchangor (as a means of conveying title to the New Property) or dissolved once all the assets have been transferred out.
  • Perfection of Interests. ensures that the EAT cannot sell the parked asset or use it as collateral for a loan.
  • Genuinely Bankruptcy Remote. In the context of a reverse exchange, bankruptcy is a very unlikely but possible occurrence. The reality is that the operating entity that owns the membership interests in one or more EATs is far more likely to have financial difficulties than the EAT itself. Provisions can be made to ensure that the bankruptcy of the Member of the EAT in a reverse exchange (typically the Accommodator Parent, sometimes the QI) does not entangle the EAT and its assets needlessly and for a lengthy period of time. However, specific provisions in the operating agreement for the EAT are necessary to ensure asset return; a generic “bankruptcy remote LLC” is really not bankruptcy-proof.
  • Assurance of Execution. It is also possible to extend the security devices implemented for a specific reverse exchange to provide an assurance of execution of the exchange. This is accomplished by a set of techniques that are proprietary to ExStra and are shared with prospective Clients only under the auspices of an agreement for non-disclosure. Please call if this is of interest.

Finding an Accommodator for a reverse exchange that satisfies all of the indicated diligence requirements and has proactively developed and implemented all of the asset security provisions described above is very easy. In fact, you have already found us!