<p>Section 1031 of the Internal Revenue Code provides taxpayers the ability to swap investment or business use real property for other like-kind property without realizing the gain, While these exchanges have been used for years by the most prudent of investors, they continue to gain traction due in part to the appreciation of real estate values. Executing a 1031 exchange can enable you to manage your real estate portfolio in a tax-efficient manner, allowing you to defer a portion or all of the taxable gains as your assets evolve. There's no limit to the number of times you can do a 1031 exchange – you can defer the gain from one piece of real estate to another, again and again. You may increase your portfolio value with each swap, but you defer the tax until you cash out only then realizing your gain.</p>

<p>The Tax Code isn’t known for its simplicity, but it’s in the details where many investors find tremendous opportunities. Revenue rulings and other administrative rulings issued by the Internal Revenue Service &amp; U.S. Treasury provide direction on various factual situations. These rulings are often relied on as precedent by taxpayers and their advisors. Revenue Procedure 2000-37 offers guidelines for taxpayers to acquire replacement property before the sale of their relinquished property. Referred to as “reverse exchanges”, this ruling goes on to inform a taxpayer they cannot own both properties at the same time, thus a “parking arrangement” must be employed - either the relinquished property or the replacement property is acquired and “parked” by an Exchange Accommodation Titleholder (also, known as an ‘EAT’). To park title means the deed of a parked property is recorded, evidencing a transfer of ownership to the EAT.</p>

<p>What does this mean? In the instance where the EAT acquires title to the replacement property, it typically does so with funds the taxpayer lends to the EAT – in most cases the taxpayer borrows to afford such an acquisition. Within 180 days, the <a href="https://www.accruit.com/blog/are-1031-reverse-tax-deferred-exchanges-re… sells the relinquished property and ownership of the replacement property is transferred to the taxpayer</a>.&nbsp;This provides taxpayers an ideal solution if they cannot delay the closing of the replacement property.</p>

<p>“The reverse exchange helps investors meet several objectives…” says Martin Edwards, JD and Managing Director at Accruit. “…some are deterred by the 45-day identification period with a traditional tax-deferred exchange but implementing a parking arrangement minimizes risk while allowing an exchanger to find and secure the best property before disposition of their relinquished property.”</p>

<p>Many consider a seller’s market (where supply is low and demand is high) the typical situation in which to implement a reverse exchange, but in fact, its application is used in a variety of market conditions. Max Hansen, JD, CES and Managing Director at Accruit says, “as we know and from 30 years of experience, markets are cyclical…real property investors can feel pressure to perform when conditions are in favor of the seller, just as much as they may feel the same pressure when it’s a buyer’s market.”&nbsp;</p>

<p>It’s the savvy real estate investors who spot fortuitous gain irrespective of which course the economy takes. Stock market volatility adds to an investor's woes if stock prices are in flux. On the other hand, real estate's relatively low correlation to stock market movements can make it a more reliable choice during a downturn, but it’s the quality of a property investment that dictates how well it performs in contrast to other securities.</p>

<p>Over a decade ago, the 2008 financial crisis and subsequent downturn that followed, saw a surge in reverse exchanges as investors sought to take advantage of low-interest rates, create wealth-building opportunities and make advantageous acquisitions. Many of those acquisitions are now paying dividends in today’s market. Despite what the current real estate environment may be, reverse exchanges can still be a powerful tool providing certainty during these uncertain times. There’s an old investing adage, that says past performance isn’t a guarantee of future performance, but real estate can prove profitable when stocks and bonds waver.</p>

<p>For more information on reverse exchanges and parking arrangements, please contact <a href="https://www.accruit.com/contact-us&quot; title="Start an Exchange with Accruit">Accruit</a>.</p>

<p>Under Revenue Procedure 2000-37, title to a relinquished or replacement property may be “parked” with an Exchange Accommodation Titleholder (EAT) until the taxpayer is able to sell the parked property to an unrelated party as part of a regular forward 1031 exchange.</p>

<p>When the reverse exchange involves the parking of a replacement property, the relinquished property needs to be sold as part of a regular forward exchange.&nbsp; After the sale of the relinquished property as part of a forward exchange,&nbsp; exchange funds are received, exchange funds are received by the qualified intermediary (QI), transferred to the EAT for the acquisition of the property being parked and then reimbursed to the taxpayer and/or lender from the EAT. The last step in a safe-harbor reverse or improvement exchange is for the EAT to convey ownership of the replacement property to the taxpayer. The transfer of ownership can be accomplished either by:</p>

<ul>
<li>Issuance of a quit claim or special warranty deed; or</li>
<li>Assignment of the membership interest in the LLC holding title to the property.</li>
</ul>

<p>In the first option, the EAT can transfer the title for the parked replacement property to the taxpayer by way of a quit claim deed or special warranty deed. Many taxpayers are familiar with conveying real estate by way of a deed.</p>

<p>Nevertheless, several administrative and financial factors exist with issuing a deed. Notably, there are hard costs associated with preparing and recording a deed. At the onset, the title company handling the replacement property purchase closing should be made aware of the reverse or improvement exchange structure as it will need to issue a “hold open” policy or some other similar policy endorsement on the title commitment.</p>

<p>Further, the lender (if any) must acknowledge and agree that the c<span style="background-color: transparent;">onveyance of the replacement property from the EAT to the taxpayer is permissible and will not trigger an event of default or due on transfer clause which would accelerate payment of the entire indebtedness encumbering the real estate.</span><!--more-->Preparation and recording charges will be incurred by the taxpayer from the title company and lender for purposes of preparing and recording the subsequent deed. Moreover, there may be additional costs such as:</p>

<ul>
<li>Reissuance of a new loan package</li>
<li>Release and recording of a new mortgage or deed of trust if there is debt encumbering the replacement property</li>
<li>Potential real estate transfer tax or exemption forms to be completed and filed with the applicable state, county, and local authorities</li>
<li>Other transactional fees related to the conveyance which can vary based on locality.</li>
</ul>

<p>After the replacement property is conveyed to the taxpayer, the titleholder LLC is then dissolved by filing Articles of Dissolution with the applicable secretary of state.</p>

<p>The second potential option is that the membership interest in the titleholder LLC, which was formed at the beginning of the parking deal to step in the shoes of the taxpayer during the parking period, may be assigned to the taxpayer. The same taxpayer requirement exists for both the relinquished and replacement properties. The exchange takes place at the entity level; therefore, the assignee of the membership interest has to be the owner of record of the relinquished property. In certain circumstances, such as when the taxpayer is an individual, grantor trust, corporation, or limited liability company, the assignment of the membership interest in the titleholder LLC may be utilized. This also applies when the taxpayer is a married couple, but only if they are in a community property state.</p>

<p>As of the effective date of the assignment of the membership interest, the EAT drops out and the taxpayer steps in as the sole member and manager of the titleholder LLC. The titleholder LLC then becomes the obligation of the taxpayer to maintain from and after the effective date of the assignment.</p>

<p>The taxpayer must inform the secretary of state of the state in which the titleholder LLC is organized, as well as any other applicable government agencies, of changes to the principal place of business and registered agent, and they must file an annual report going forward to keep the entity in good standing. If an EIN was obtained for purposes of the replacement property purchase, it will also be transferred to the taxpayer. The taxpayer will have limited liability protection under the state law governing LLCs but should also consider having an amended and restated operating agreement prepared by its own independent legal professional to reflect the new ownership and management organization. On limited occasions, there still may be local, county and state transfer tax considerations associated with assignment of the membership interest as well.</p>

<p>Depending on the facts and circumstances surrounding the parking arrangement, it may be more cost effective, efficient and desirable from a limited liability perspective to utilize an assignment of the membership interest on the back end to wrap up a parking deal instead of a deed.</p>

<p>As with all matters concerning 1031 exchanges, it is highly advisable to consult with an independent professional regarding the legal and tax consequences associated with either using a deed or an assignment of membership interest in the titleholder LLC for purposes of concluding a reverse or improvement exchange transaction.</p>

<h2>What is a Reverse Exchange and What Causes it to Fail?</h2>

<p>A conventional <a href="/blog/are-1031-reverse-tax-deferred-exchanges-real-estate-approved-irs">IRC §1031 tax deferred exchange</a> involves, among other things, a taxpayer’s sale of old property (the “relinquished property”) followed by the purchase of new property (the “replacement property”) within a 180 day period. A so-called reverse exchange takes place when the taxpayer is forced to acquire the replacement property, or face losing it, prior to the sale of the relinquished property.&nbsp; The sequence of the disposition and acquisition is “reverse” from the conventional transaction. There are special IRS rules that provide a “safe harbor” <a href="/blog/are-1031-reverse-tax-deferred-exchanges-real-estate-approved-irs">to accomplish a reverse exchange</a>.&nbsp; The technique is much more complicated than a conventional exchange and pricier too.&nbsp; But many people enter into such transactions because the benefit far outweighs the complexities and higher cost.</p>

<p>The reverse exchange rules require the taxpayer to sell the relinquished property within 180 days of the facilitator’s acquisition of the replacement property on behalf of the taxpayer.&nbsp; On occasion, the taxpayer, for a variety of reasons, is unable to get the relinquished property sold within that time frame.&nbsp; Without further structuring, the transaction will fail at the end of 180 days.&nbsp; Not only does the taxpayer lose the time, effort and costs, but more importantly, the treatment of the new property as the replacement property for the sale of the old property is lost.&nbsp; The taxpayer simply owns the replacement property directly and not as a part of an exchange.</p>

<h2>What is a White Knight and How does it Rescue the Failing Reverse Exchange?</h2>

<p>As explained above, the inherent problem is that the taxpayer is unable to find a buyer within the 180 day time frame.&nbsp; However should the taxpayer be able to find an accommodating party to buy the property, as a favor to the taxpayer, to enable him or her to recognize a sale within the applicable time period that is treated the same as a sale to a “real” buyer.&nbsp; The accommodating party can be a friend, family member or other relative.</p>

<h2>Isn’t a Related Party Prohibited from Doing an Exchange with the Taxpayer?</h2>

<p>Some family members are defined as “related parties” (such as lineal descendants) while some are not so defined (such as aunts/uncles, nephew/niece, in-laws).&nbsp; So the accommodating party may be a family member that is not deemed a related party, however this technique should still work even if the party is a related party. &nbsp;While the “Related Party” provisions contained in the rules do generally prevent a taxpayer purchasing replacement property from a related party, those rules do not prohibit <a href="/blog/1031-tax-deferred-exchanges-between-related-parties">selling relinquished property to a related party</a>.&nbsp; Essentially sales to a related party can result in a basis shift that the IRS considers “abuse” of the rules.&nbsp; Basically it is like “gaming the system”.&nbsp; But a purchase of relinquished property does not result in the same type of basis shifting.&nbsp; It is generally not considered a problem in an exchange context.</p>

<h2>So How Exactly Does this Work?</h2>

<p>Simple.&nbsp; Just like the proverbial White Knight riding in at the last minute to rescue the damsel in distress, in the exchange context, the friendly party’s purchase of the property from the taxpayer just prior to the expiration of the 180 day period, allows the taxpayer to meet the necessary time deadlines.&nbsp; The friendly party can continue to market the property for sale and once sold, no matter how long it takes, everyone is made whole using the proceeds from the sale to the true buyer.</p>

<h2>What are the Options on Financing the Purchase from the Taxpayer?</h2>

<p>This is not quite as simple.&nbsp; This can be accomplished in a number of different ways.&nbsp; The friendly party can take the property subject to any underlying mortgage against the property (be cognizant of any due on transfer clause in the mortgage) and can pay cash for the balance. Alternatively, the balance can be financed by the taxpayer so that the friendly party does not have to come up with cash personally.&nbsp;</p>

<p>Reverse exchanges are begun with the taxpayer retaining the services of an exchange company to acquire and hold the replacement property for the taxpayer per the reverse exchange rules.&nbsp; It is quite common that the taxpayer provides, through a loan to the exchange company, for the funds needed for the exchange company to acquire the property.&nbsp; In most exchange transactions, when money from the sale of the relinquished property flows through the exchange process, those proceeds are cycled through and are used to repay the taxpayer’s original acquisition financing.</p>

<p>In addition to having financed the exchange company’s original purchase of the replacement property, in this White Knight scenario, as mentioned above, the taxpayer also often finances the friendly party’s acquisition of the relinquished property.&nbsp; In that case, the buyer’s note gets cycled through the process and ends up going back to the taxpayer, just as cash would in a typical reverse exchange, to pay off the taxpayer’s acquisition financing. &nbsp;When the dust settles, the taxpayer made his or her necessary deadlines, owns the replacement property and holds a note on the sale of the relinquished property to the friendly party. Whenever the friendly party is able to sell the property to a true buyer, any underlying mortgage is paid off and what is left goes back to the taxpayer to pay off the note held by the taxpayer.</p>

<p>A recent transaction which took place in our office should provide further clarification of the process.</p>

<h2>A Recent Case Study</h2>

<p>In the spring of this year a client called seeking reverse exchange service.&nbsp; The client was buying a small strip center for $1,250,000.&nbsp; The relinquished property, a commercial condominium unit valued at $500,000, was listed for sale but not under contract at the time of the replacement property closing. The client lent the exchange company $1,250,000 to cover its purchase of the replacement property (sometimes a bank may make all or part of these loans).&nbsp; Nearing the end of the 180-day period, it became clear that the relinquished property would not be under contract, or closed, within the necessary time frame.</p>

<p>The client prevailed on his father-in-law to purchase the condominium unit.&nbsp; There was a $250,000 mortgage in place, so the relative took title subject to the mortgage balance and the client took back a note for $250,000 for the balance of the purchase price.&nbsp; Alternatively, the father in law could have paid $250,000 in cash, but that was not the facts here.&nbsp; The sale of the relinquished property took place within 180 days of the acquisition of the replacement property and the client adhered to all necessary time frames.</p>

<p>Several months later, a third-party buyer was found for the property and paid $500,000 for it.&nbsp; The father-in-law was the nominal seller.&nbsp; The first $250,000 went to retire the underlying mortgage and the other $250,000 went to repay the client loan to the relative.&nbsp;</p>

<h2>View the entire <a aria-label="10 Steps of Reverse Exchange" href="/sites/default/files/files/Reverse%201031%20infographic.pdf" title="10 Steps of Reverse Exchange">10 Steps of a Reverse Exchange Infographic</a>.</h2>

<p>Accruit, LLC is a national provider of <a aria-label="1031 Exchange Qualified Intermediary" href="https://www.accruit.com/blog/how-choose-qualified-intermediary-your-103…; title="1031 Exchange Qualified Intermediary">1031 Exchange Qualified Intermediary</a> (QI) and Exchange Accommodation Titleholder (EAT) services for simple and complex exchanges. Accruit handles all types of real property like-kind exchanges. Specialized EAT services are provided by Accruit Exchange Accommodation Services LLC.</p>

<p>A reverse exchange is a tax-deferred exchange that enables the purchase of new (replacement) property prior to the sale of the old (relinquished) property.</p>

<h2>Step One</h2>

<p><img alt="Reverse Exchange Step One" src="/sites/default/files/files/Reverse%201031-Step%201.png" style="width: 704px; height: 348px;" /></p>

<p>The taxpayer enters into a contract to purchase the replacement property, assuring the contract has no restriction against assigning the contract to a third party. In the unlikely event that it is so restricted, the contract should be negotiated to allow the contract to be assigned to the reverse exchange accommodator, Accruit Exchange Accommodation Services (AEAS) or a special purpose entity (SPE), typically an LLC, owned by AEAS to hold title to the property. Under IRS vernacular, the SPE is known as an Exchange Accommodation Titleholder (EAT).</p>

<h2>Step Two</h2>

<p><img alt="Reverse Exchange Step Two" src="/sites/default/files/files/Reverse%201031-Step%202.png" style="width: 704px; height: 533px;" /></p>

<p>The taxpayer or their advisor contacts Accruit to start an exchange and obtain a reverse exchange document package. The taxpayer and AEAS, enter into a Qualified Exchange Accommodation Agreement (QEAA) for replacement property whereby the SPE, as the EAT, will take title on the date of closing to the replacement property. The SPE is set up with AEAS&nbsp;as its sole member.</p>

<h2>Step Three</h2>

<p><img alt="Reverse Exchange Step Three" src="/sites/default/files/files/Reverse%201031-Step%203.png" style="width: 704px; height: 415px;" /></p>

<p>The taxpayer assigns the replacement property purchase contract to the EAT.</p>

<h2>Step Four</h2>

<p><img alt="Reverse Exchange Step Four" src="/sites/default/files/files/Reverse%201031-Step%204.png" style="width: 704px; height: 409px;" /></p>

<p>Unless the taxpayer is providing 100% of the necessary funds, a taxpayer selected lending bank loans the funds required for the purchase to the EAT to enable it to acquire the replacement property. The EAT signs any applicable loan documents as the borrower, however, the taxpayer signs as the guarantor of any such loan. In the event the bank does not make a 100% loan-to-value loan, the taxpayer makes a second loan for the balance needed, which should include any earnest money that may have been previously advanced. The documents required for any taxpayer loan are furnished by Accruit and typically include a Non-Recourse Promissory Note and a Pledge Agreement of Membership Interest to secure the loan.</p>

<h2>Step Five</h2>

<p><img alt="Reverse Exchange Step Five" src="/sites/default/files/files/Reverse%201031-Step%205.png" style="width: 704px; height: 481px;" /></p>

<p>The taxpayer and the EAT enter into a contract for the sale of the replacement property from the SPE to the taxpayer as well as a triple net Master Lease, which allows the taxpayer to oversee the day-to-day management of the property while it is held by the EAT. The lease provides that, in lieu of rent, the taxpayer will pay all debt service to the lender and/or the taxpayer, assuming a secondary loan from the taxpayer. Accruit may request that the taxpayer execute an Environmental Indemnity Agreement.</p>

<h2>Step Six</h2>

<p><img alt="Reverse Exchange Step Six" src="/sites/default/files/files/Reverse%201031-Step%206.png" style="width: 704px; height: 364px;" /></p>

<p>Funds are sent directly to the closing by the lender and/or the taxpayer. The closing takes place and the SPE takes title to the property. Evidence of liability insurance must be furnished to Accruit showing the SPE as the insured party, while the lender and the taxpayer may appear as additional insureds.</p>

<h2>Step Seven</h2>

<p><img alt="Reverse Exchange Step Seven" src="/sites/default/files/files/Reverse%201031-Step%207.png" style="width: 626px; height: 600px;" /></p>

<p>Within six months (180 days) of the replacement property closing, the taxpayer enters into a contract for the sale of the relinquished property and enters into a standard Tax Deferred Exchange Agreement with Accruit, who serves as the QI. The taxpayer assigns its rights (but not its obligations) under the contract for the sale of the relinquished property to the QI and gives to the buyer(s) written notice of this assignment on or before the closing. The closing must take place within the 180-day period and the net proceeds of the sale are paid to the QI.</p>

<h2>Step Eight</h2>

<p><img alt="Reverse Exchange Step Eight" src="/sites/default/files/files/Reverse%201031-Step%208.png" style="width: 704px; height: 391px;" /></p>

<p>The taxpayer assigns its rights under the contract for the purchase of the replacement property (which is now being acquired from the EAT) to the QI and gives written notice of this assignment to the EAT, on or before the closing.</p>

<h2>Step Nine</h2>

<p><img alt="Reverse Exchange Step Nine" src="/sites/default/files/files/Reverse%201031-Step%209.png" style="width: 704px; height: 535px;" /></p>

<p>The taxpayer directs the QI to disburse the exchange proceeds to the EAT as part, or all, of the purchase price. The EAT receives the funds and immediately wires those funds to the lending bank and/or to the taxpayer to pay down all or part of the debt.</p>

<h2>Step Ten</h2>

<p><img alt="Reverse Exchange Step Ten" src="/sites/default/files/files/Reverse%201031-Step%2010.png" style="width: 704px; height: 339px;" /></p>

<p>The taxpayer takes ownership of the replacement property via an assignment of the membership interest in the EAT which transfers the LLC, and the property it holds, from the member (AEAS) to the taxpayer. Alternatively, a deed may be issued to the taxpayer by the EAT and the LLC may be dissolved. The taxpayer takes the membership interest or the deed relating to the replacement property subject to the balance of any debt.</p>

<p><em>Note: The foregoing suggested procedural outline is made available by Accruit to interested parties and to licensed attorneys and it is intended to be used as a guideline. It is not intended to be relied upon, or viewed in any way, as legal advice, and is furnished for purposes of convenience only. As a qualified intermediary, Accruit is prohibited from providing tax or legal advice. Taxpayers must seek such counsel from their advisors.</em></p>

<p>&nbsp;</p>

<hr />
<p>&nbsp;</p>
<!--HubSpot Call-to-Action Code -->

<p style="text-align:center"><a href="https://cta-redirect.hubspot.com/cta/redirect/6205670/914580be-98fb-4bc…; target="_blank"><img alt="Start Your 1031 Exchange with Accruit today" class="hs-cta-img" height="282" id="hs-cta-img-914580be-98fb-4bcd-896e-3085b6212867" src="https://no-cache.hubspot.com/cta/default/6205670/914580be-98fb-4bcd-896…; style="border-width:0px;" width="765" /></a></p>

<p>Download the free step-by-step guide, <a href="https://info.accruit.com/reverse-exchange-whitepaper">Parking the Relinquished Property in a Reverse Exchange</a>.</p>

<h2>The Facts</h2>

<p>We were contacted by a potential client about doing an Internal Revenue Code (IRC) §1031 tax deferred exchange.&nbsp; The client needed to acquire, or risk losing, the desired replacement property (new property) in Dillon, Colorado. However, the contract with his buyer for the sale of his relinquished property (old property) in Littleton, Colorado was not scheduled to close until November 28, 2014, a month after the date of closing for the new property.&nbsp; The purchase price for the new property was $562,000.&nbsp;</p>

<p>In a normal tax deferred exchange, or “forward exchange,” the taxpayer sells the relinquished property first and uses the exchange proceeds to acquire the replacement property.&nbsp; This situation, in which the taxpayer needs to take ownership of the new property prior to the sale of the old property, i.e. in a reverse sequence, is referred to as a “reverse exchange.”</p>

<h2>The Problem</h2>

<p>The client wanted to do an exchange of his old property for the new property but was unable to find a buyer for his old property prior to the scheduled closing of the new property.&nbsp; Unfortunately, the IRS does not recognize the validity of a “pure reverse exchange,” in which the taxpayer acquires the new property before the sale of the old property.</p>

<h2>The Options</h2>

<p>In response to this common conundrum, the IRS issued <a href="/exchange-library/rev-proc-2000-37-reverse-exchanges">Revenue Procedure (Rev. Proc.) 2000-37</a>&nbsp; to enable taxpayers to effectively buy before selling.&nbsp; There are two approved solutions:</p>

<ol>
<li>The exchange company purchases the taxpayer’s old property and holds it pending the sale of that property to a bona fide third party buyer.&nbsp; This is sometimes referred to as an “exchange first” reverse exchange.</li>
<li>The exchange company to <a href="https://info.accruit.com/reverse-exchange-whitepaper">acquire title to the replacement property and park it on behalf of the taxpayer</a> until the taxpayer sells the old property. This is sometimes known as an “exchange last” reverse exchange.&nbsp;&nbsp;</li>
</ol>

<p>When the exchange company services a routine forward exchange, it acts as a qualified intermediary (QI).&nbsp; When, as in the two options above, an exchange company services a reverse exchange in which it has to take title to a property, the Rev. Proc. refers to this as acting as an exchange accommodation titleholder (EAT). There are several factors for the taxpayer, their advisors and their exchange company to consider when determining whether the old property or the new property is better to park with the EAT. Those considerations may include:</p>

<ul>
<li>What are the relative values of the properties (e.g. the old property may have a value of $100k and the replacement property $1MM)?</li>
<li>Is the old property subject to debt?</li>
<li>Are there any transfer tax considerations in connection with parking either property (there is some authority that <a href="/exchange-library/irs-private-letter-ruling-200148042">parking transactions are exempt from transfer taxes</a>)?</li>
<li>Are there any environmental issues associated with either property?</li>
<li>Are there special financing issues surrounding the replacement property such as a HUD loan, TIF (tax incremental financing), Enterprise Zone, etc.?</li>
</ul>

<p>In an exchange-first reverse exchange, the EAT takes title to the old property and “parks,” or holds title to that property until the taxpayer is able to arrange a sale of that property to a third party buyer.&nbsp; For Section 1031 purposes, this acquisition by the EAT constitutes a “sale” by the taxpayer and this sale allows the taxpayer to restructure the transaction by “selling” the old property before buying the new property.&nbsp;</p>

<p><img alt="Parking the Relinquished Property in a Reverse 1031 Exchange" src="/sites/default/files/files/parking-relinquished-property-2.jpg" style="width:550px; height:319px; margin-left:5px; margin-right:5px; float:right" />Conceptually this is no different than the taxpayer finding a ready, willing and able buyer of the old property who is able to close on the purchase from the taxpayer just prior to the taxpayer’s acquisition of the new property.&nbsp; Since the structure allows a sale before the purchase, the sale and purchase become a standard exchange using a Qualified Intermediary to link the sale to the purchase.&nbsp;&nbsp; Use of the reverse exchange does not remove the need to do a standard forward exchange, rather the reverse exchange requires use of the EAT to acquire the property and use of the QI to affect an exchange of the old property for the new property.</p>

<p>In this type of reverse exchange, the EAT, having acquired the old property from the taxpayer, later becomes the property’s seller to an actual buyer identified by the taxpayer.&nbsp; Under the reverse exchange rules, the taxpayer has 180 days (or less, depending upon the tax return filing date for the year in which the property parking takes place)&nbsp; to arrange a sale to a third party.&nbsp;&nbsp;</p>

<p>At times, the taxpayer is unable to find a buyer within this time period or “parking period.”&nbsp; In this case the reverse exchange expires and the EAT simply transfers the old property back to the taxpayer.&nbsp; When this happens there is no valid exchange by the taxpayer of the old property for the new property. The taxpayer may still wish to do a conventional forward exchange upon the sale of the old property, but a new replacement property would need to be identified and acquired as part of that new forward exchange.</p>

<p>If, when the old property is being parked, it is already under contract, then the sale value is certain.&nbsp; More often than not, it is not under contract, and the taxpayer has to estimate the market value for the sale to the EAT, an estimate which may be higher or lower than the eventual sale price to the third party buyer.&nbsp; The drafters of the Rev. Proc. foresaw the difficulty in exactly pinpointing the sale price in advance of an actual contract with the third party buyer, and the Rev. Proc. allows the taxpayer and EAT to retroactively modify the values used at the time of the property parking to correspond with the actual facts:&nbsp; It is permissible that:</p>

<blockquote>
<p>“the taxpayer and the exchange accommodation titleholder enter into agreements or arrangements providing that any variation in the value of a relinquished property from the estimated value on the date of the exchange accommodation titleholder's receipt of the property be taken into account upon the exchange accommodation titleholder's disposition of the relinquished property through the taxpayer's advance of funds to, or receipt of funds from, the exchange accommodation titleholder."</p>
</blockquote>

<h2>The Solution</h2>

<p>Returning to our client, the old property had the estimated value of $163,000.&nbsp; The new property was under contract for $562,000.&nbsp; In this case, the old property had no debt on it, and the transaction began with a cash loan from the client to the EAT in the amount of $163,000.&nbsp; In the event the old property had debt on it, the EAT could acquire it for the value of the equity and take title subject to the existing debt.&nbsp; In this case, if the old property had had $100k of debt, the property could be sold to the EAT for $63k.&nbsp; Be cognizant of any “due on sale/transfer” provisions in connection with the debt.</p>

<p>This loan was documented by a note and secured by a pledge of the membership interest in the special purpose entitiy that was set up by the EAT, the taxpayer or their attorney to hold title.&nbsp; The sale of the old property to the EAT took place on October 23, 2014.&nbsp; The client directed that the funds be placed in his forward exchange account, and he used those funds towards the purchase of the new property on October 28, 2014.&nbsp;&nbsp;&nbsp; The client borrowed the difference of $399k from a bank lender to reach the total purchase price of $562k.&nbsp;&nbsp;</p>

<p>The old property was sold by the EAT to the third party buyer on November 28, 2014, as originally scheduled.&nbsp; The proceeds of the sale went to pay off the original cash loan from the client to the EAT and the LLC was dissolved.</p>

<p>Relinquished property reverse exchanges are documented as follows:</p>

<ul>
<li>Exchanger Information Form</li>
<li>A Qualified Exchange Accommodation Agreement (the reverse exchange agreement)</li>
<li>Sale contract between the taxpayer as seller and the EAT as buyer</li>
<li>Note from EAT to taxpayer in the amount lent to the EAT</li>
<li>Pledge of membership interest in the special purpose limited liability company used by EAT to take title to the property</li>
<li>Master Lease from the EAT to the client enabling the taxpayer to enter into tenant leases directly with the tenants and to provide property management to remain with the taxpayer</li>
<li>Environmental Indemnity Agreement from taxpayer to EAT</li>
<li>Property liability insurance in the name of the EAT</li>
</ul>

<h2>The Result</h2>

<p>The client used the reverse exchange safe harbor to effectively sell the relinquished property prior to the purchase of the replacement property and achieved tax deferral on the entire gain associated with the relinquished property.</p>

<p>The financial and operational efficiency benefits of a 1031 exchange are well established. But what if your business isn't in a position to sell an asset before you buy the replacement? Maybe you haven't identified a buyer yet, or perhaps your situation requires you to keep using the existing asset until the replacement is online and ready to go?</p>

<p>In these sorts of situations a 1031 like-kind exchange might make financial sense, but not logistical sense.</p>

<p>The good news is that the tax code allows what's known as a "reverse exchange," which lets you buy the replacement asset first and sell the relinquished asset later. You can keep using your existing asset in the meantime, and you still get all the benefits of a forward exchange - that is, the ability to defer recognition on the gain from the sale, which can exceed 40% of the proceeds in some cases.</p>

<p>Reverse exchanges aren't as well known as other types of 1031 exchange and we get a lot of questions about how they work. So we've pulled together a more detailed resource that explains what it is, how it works, etc. We encourage you to take five minutes and have a look.</p>

<ul>
<li>Learn more about 1031 reverse exchanges of real estate</li>
<li>1031 reverse exchanges</li>
</ul>