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 a Relinquished 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 Replacement Property and needs to close its purchase soon in order to secure the deal, a reverse exchange is indicated. Other constraints are the result of the way the purchase of the Replacement Property is financed. For example, if an Exchangor simply cannot acquire a Replacement Property prior to the sale of the Relinquished Property, with the resulting availability of the cash proceeds, then a delayed exchange is the only option. For other types of assets, the need to keep the Relinquished Property in place until the Replacement Property is fully available will dictate the choice of strategy. For example, if the Relinquished Property is a manufacturing facility that must remain in operation until the new facility – the Replacement Property - is up and running, which would dictate a reverse exchange or an improvement exchange. 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 in which a reverse exchange is a better way to go forward. The frequency with which this is true is often quite surprising. This is often because the educational efforts of the QI industry at large 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.
An optimal exchange strategy delivers the best Return on Capital (“ROC”) to the Exchangor. Delayed exchanges involve the liquidation of the Relinquished 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 1%, perhaps 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. ROC) 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 ROC to the Exchangor. In a delayed exchange, virtually all of the ROC 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 or by going to Resources. 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.
The potential to defer capital gains tax on the sale of Relinquished 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 Replacement 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 is 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.
In a delayed exchange, the Exchangor has 45 days to identify candidate Replacement 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 Relinquished 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 Exchangor’s 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 Replacement 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 Replacement Property is acquired. The Exchangor then has 45 days to identify potential Relinquished Property to be sold. It is important to appreciate this difference: identifying potential Replacement 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 Relinquished Property.
Furthermore, if a reverse exchange is in danger of failing because the Relinquished 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 Replacement Property and the Relinquished Property. This may place some stress on the financials of the Exchangor but the Relinquished Property can, hopefully, be included in another exchange at a later time. The benefit of this approach is that there is no gain to defer since no sale of the Relinquished Property has occurred! Secondly, the Exchangor may have the option to “extend” the reverse exchange using a process that involves non-safe-harbor structures to complete the reverse exchange while providing more time to sell the Relinquished 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.
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 Relinquished Property – thereby making it unavailable to the Exchangor – if there will be any substantive delay in acquiring the Replacement Property. For example, if the Relinquished Property is a warehouse or production facility, it may be absolutely necessary to keep the asset functioning while the Replacement Property is acquired and brought up to functional status.
Optimizing asset utilization results in improved ROC and fewer failed exchanges.
In every 1031 exchange, whether deferred or reverse, the Exchangor entrusts valuable assets to their 1031 Accommodator. In the case of a deferred exchange, the cash proceeds from the sale of the Relinquished Property are held by the QI until the purchase of a Replacement Property is closed. In the case of a reverse exchange, the Accommodator holds legal title to either the Relinquished or the Replacement 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 by statute 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:
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!