A reverse exchange is a 1031 exchange in which the Replacement Property (“RP”) is acquired before the Relinquished Property (“RQ”) is sold. The role of the Accommodator is to acquire either the RP or the RQ on behalf of the Exchangor and hold legal title to it until the Relinquished Property is sold to its ultimate buyer. The asset held in this manner is frequently said to be “parked” and the formal agreement between the Accommodator and Exchangor describing the parking arrangement is called the Qualified Exchange Accommodation Agreement or “QEAA”.
In any reverse exchange, the Accommodator should form a separate business entity to hold the property to be parked during the exchange. This entity – called the “Exchange Accommodation Titleholder” or EAT – is usually a single-member LLC. Using this approach, the assets in each exchange are kept legally separate and insulated from one another.
The formal IRS guidance regarding reverse exchanges is found in IRS Rev. Proc. 2000-37. It describes the “safe harbor” upon which the reverse exchange processes described below rely. It says that the IRS will not challenge the status of an EAT as the beneficial owner for tax purposes of an asset involved in a parking arrangement (i.e. a reverse exchange) if the QEAA between the Exchangor and Accommodator meets its requirements and if the standard exchange deadlines are met. The standard deadlines apply to the identification and sale of the Relinquished Property, as opposed to the identification and acquisition of potential Replacement Property. Thus, there are 45 days to identify potential one or more RQs to be sold and 180 days to complete the exchange by selling one or more of the RQs that have been properly identified. The Rev. Proc. also permits a series of arrangements in support of the parking arrangement that are not required to be at “arm’s length”. For example,
The Exchange Last is the most basic form of reverse exchange. In this form, an EAT is formed that will take title to and hold the RP while the Exchangor finds a buyer for the RQ and consummates a sale. If the Exchangor has enough cash to acquire the RP without a loan, then the EAT will issue an interest-free Note to the Exchangor for the purchase money and will enter into a rent-free triple-net Lease with the Exchangor that provides total access to the RP as well as the ability for the Exchangor to sub-lease and to collect and keep all rents. Identification of one or more candidate RQs must occur within 45 days and the sale of one or more identified properties must occur within 180 days. Once a sale is imminent, a deferred 1031 exchange is conducted in which the Exchangor, through the QI, is the seller of the RQ to its ultimate buyer and the EAT is the seller, through the QI, of the RP to the Exchangor. (Conducting the deferred exchange, often over only one or two days, at the end of the reverse exchange process is the reason that this form is called “Exchange Last”). As part of the exchange, there is a settlement process, conducted by a QI, in which the purchase price for the RP is “paid” to the EAT by the Exchangor while exactly the same amount of money is used to retire the Note from the EAT held by the Exchangor. Exchangors may elect to either take direct title to the RP or to take an assignment of all the membership interests in the LLC underlying the EAT.
If the RQ cannot be sold in the 180-day exchange period, then the reverse exchange fails. In this case, the EAT will sell the RP to the Exchangor “at cost” and use the funds to retire the Note. When an Exchange Last fails, the result is that the Exchangor owns both properties, one more than initially contemplated, but there is no taxable event associated with the RQ because no sale has occurred.
In many Exchange Last transactions, there is a third-party lender (for example, a bank) that supplies some or all of the purchase money for the RP. If so, it is likely that there will be loan documents between the EAT and the lender in addition to the EAT’s Note to the Exchangor. If the EAT enters into third-party loan documents, there will typically be a guarantee provided to the lender by the Exchangor as well as a Deed of Trust, Mortgage or other security instrument. At the conclusion of the exchange, both the third-party loan and the Note held by the Exchangor can be retired at settlement. However, it is far more likely that the lender will encourage or require that the loan to the EAT remain in place and that the Exchangor assume the membership interests in the LLC as a means of transferring ownership of the RP. The LLC assignment approach is often more attractive in real estate exchanges because it nearly always eliminates the need for a second title insurance policy, for rewriting the property and casualty insurance policy and may eliminate the need to pay real estate transfer taxes twice.
The other basic form involves the transfer of the RQ to an EAT as part of a deferred 1031 exchange at the beginning of the process (hence, the term “Exchange First”). The QI conducts a deferred 1031 exchange in which the EAT, through the QI, is the buyer of the RQ and the Exchangor, through the QI, is the Buyer of the RP. The Exchangor acquires the RP directly from its seller and takes title to it without the involvement of an EAT. The QEAA stipulates that it is the Exchangor’s responsibility to find a buyer for the RQ and consummate a sale within the 180-day exchange period. When a buyer is found, the Exchangor negotiates a purchase and sale contract on the EAT’s behalf and title is then transferred from the EAT to the buyer in a normal settlement process.
If the RQ is not sold with 180 days, the best approach is to conduct a rescission of the sale of the RQ to the EAT so that no taxable event has occurred. If done properly at the end of a failed Exchange First, the rescission results in the Exchangor owning both properties but having no gains associated with the sale of the RQ.
Choosing between the basic forms is seldom difficult. An Exchange Last is probably best if:
An Exchange First is the usual choice if there are issues regarding financing of the RP purchase because an EAT is involved. Many lenders, especially if the RP is residential real estate, will not agree to have title (temporarily) held by an LLC, much less an EAT. In this case, a discussion with the QI regarding the exact status of any debt on your RQ and the potential deferment of gain involving your RQ at the beginning of the exchange will be critical to a successful strategy.