A hybrid exchange is a one in which basic exchange forms are combined in a serial or overlapping fashion to accomplish a particular goal involving multiple Relinquished Properties (“RQ”) or Replacement Properties (“RP”). These structures can provide more time - perhaps up to 360 days – to accomplish the goal.
Suppose that an Exchangor would like to acquire two RQs as part of an exchange for a single RQ and that the value of each RP is less than that of the RQ but the combined values of the RQs exceed that of the RQ.
For example, let’s say that our hypothetical Exchangor has an older apartment building (the RQ) with limited future potential for appreciation and/or income growth and wants to exchange it for two single-tenant, net-lease properties (the RPs) that have good income and other attractive financial incentives. Suppose further that the total time that will be needed to acquire both RQs and sell the RQ will very likely be longer than 180 days. The following strategy will provide more time:
As a second example, suppose that the Exchangor has two older RQs of equal value and wants to exchange into a single net-lease property but the close date of the RP is 120-150 days out. The following strategy, which begins with a deferred exchange instead of an Exchange Last, may work:
Of course, all of the normal caveats regarding 1031 exchange still apply in these examples. There may still be potential for boot, for example, if the sale price of RQ exceeds that of the RP or if equity is replaced by debt. And, there is always the chance that the sale of a particular RQ will not occur within the required 180-day window (the window being determined by the other events in the strategy, of course). But, all these “common denominator” considerations aside, these strategies provide many investors the opportunity to consolidate or expand in the context of fully-compliant 1031 exchanges over a period of up to 360 days.
Assume that the Exchangor is a corporation that has multiple RQs to sell and a desire to make improvements to RP that they plan to acquire. The first step in this strategy is a standard improvement exchange in which the RP is parked with an EAT and improvements are made to it while parked. Once the first RQ is sold, the proceeds are held by a QI pursuant to a deferred exchange arrangement. During this time, the EAT continues to make improvements to the RP. On the 179th day of the reverse exchange, a second and unrelated EAT (“EAT-2”) will enter into a long-term lease with the first EAT for the RP. The first deferred exchange will be completed the next day, with the RP having a value of the original acquisition cost plus the improvements made to date. EAT-2 will make further improvements using funds provided by the Exchangor. Assuming that the second RQ is sold in the 180-day period following the start of the second reverse exchange, the final step will be the exchange of the second RQ for the leasehold interests plus the improvements.
Assume that the Exchangor, let’s call her Debra, holds title to two potential RQs, one directly and one in an LLC owned by Debra and her sister (LLC-1). A separate LLC (LLC-2) owned by Debra and her sister holds title to vacant land (the “Land”) on which Debra would like to build a bowling alley. Debra would like very much to exchange the RQs for the bowling alley. A strategy using two leasehold improvement exchanges may make this possible. Since the vacant land is held in a separate affiliate, a leasehold improvement exchange can be used to exchange the first RQ for part of the improvements to the Land. As we have seen, this is accomplished by having the LLC holding title to the Land enter into a long-term lease with an EAT and completing the exchange (after Debra’s sale of the first RQ) by assigning the interests in the EAT to Debra. On the 179th day of the first exchange, a long-term sub-lease will be entered into, this time between Debra and a second and unrelated EAT (“EAT-2”). This sub-lease will give EAT-2 use of the Land plus the improvements made to date. On the 180th day, the first exchange will be completed, with the Debra reporting the exchange on her tax returns at the appropriate time. The RP for this exchange will consist of the leasehold interest in the Land and the improvements made to it so far.
For the second phase, EAT-2 will continue to make improvements using funds loaned to it by LLC-2. Assuming that the second RQ is sold by LLC-2 within 180 days of the start of the second reverse exchange, a delayed exchange will be done and the funds from the sale will be available to finance additional improvement to the Land. The whole strategy will conclude on the 180th day of the second reverse exchange when the second delayed exchange is completed with the RP being the sub-leasehold interests in the Land and the accumulated improvements then owned by EAT-2.
The ability to extend the time to sell or buy multiple properties involved in a strategy can be very valuable and the above techniques suggest real ways to construct such a strategy. Clearly, specific facts and circumstances will have to be examined carefully in order to develop the particular strategy that will work. And, it goes without saying, that these strategies should be applied to situations in which the potential economic benefits have been carefully assessed and determined to warrant the cost and effort of implementation.