DEMYSTIFYING THE REVERSE EXCHANGE

Reverse exchanges are gaining in popularity, but they are often misunderstood and they can be confusing. Let's investigate the basics of this exchange structure.

Sometimes a situation arises in which an investor or property owner wants to purchase a property before he is able to sell property he already owns to provide the funds needed to purchase the new property. If the old property is able to be sold prior to closing on the new property, the investor can employ a standard Section 1031 exchange to defer capital gain taxes on the sale. But sometimes the timing is such that selling first isn't possible. In those situations, a reverse exchange can provide the investor the alternative he or she needs to still take advantage of the tax deferral on the sale of the old property.

How does it work? Let's boil it down to the essentials. In a standard exchange, there are four parties involved:

The exchanger (you)
The intermediary (us)
The buyer of the relinquished (old) property
The seller of the replacement (new) property.

A reverse exchange adds a fifth party - a single-purpose entity that is formed by the intermediary to hold title to either the relinquished property or the replacement property; nearly always it's the replacement property, though. This title-holding entity is known in exchange parlance as an Exchange Accommodation Titleholder, or EAT. Its sole purpose is to hold title to one of the properties, providing time for the relinquished property to sell.

As we go through the steps of a reverse exchange, you will see that the term itself is a bit of a misnomer. Nothing is actually done in reverse order. Having the EAT hold the new property merely postpones a standard exchange until the old property sells.

Once the EAT takes title to one of the properties, the clock starts. The rules allow 180 days to sell and close the relinquished property. When that happens, the intermediary proceeds with a standard exchange: the proceeds of the sale come to the intermediary and are then transferred back out to allow the exchanger to acquire the property that has been held from the EAT to the exchanger. The risk to the exchanger is that the old property does not sell within the 180 days. If that happens, the reverse exchange has failed and title to the new property will be passed to the exchanger, who will then own both the old property that didn't sell and the new property. Best advice—do what you need to do to get the old property sold during the 180-day period.

It might have occurred to you by now that, with the money to purchase the new property wrapped up in the old property, the EAT must be a really great guy to buy the new property for you and hold it until you can sell the old one. While it may be true that the EAT is a really great guy, he will not use his own money to purchase the new property for you. The funds to purchase the new property must be provided by the exchanger. There are essentially three means by which the exchanger can provide those funds: 1) he can provide cash from his back pocket or a handy bank account, or 2) he can work with his bank, or a willing uncle/friend, and the EAT to structure a loan for the new property, or 3) a combination of #1 and #2. The EAT will not want to assume any liability for the loan on the new property, but the exchanger may sign the loan papers and be liable for the debt. The lender may require additional collateral as well. While it can be cumbersome to structure such a loan, it is something we're experienced with and we're confident we can help your bank understand and accept the arrangements.

There are two other important documents that are typically part of a reverse exchange. If the funds to purchase come from the exchanger, the EAT will execute a note that shows the funds that were loaned to the EAT to purchase the property. Other written assurances can also be provided to assure the exchanger that the EAT will pay back those funds when the closing that ultimately transfers the new property to the exchanger occurs. The second document is a net lease between the EAT and the exchanger. The net lease makes the exchanger responsible for payment of all expenses of the new property, just the same as if he or she owned it. The lease payments, if any, can be equal to any payments made on any interest due on the bank loan, if any. The lease is designed to be strictly a pass-through, allowing the EAT to cover any expenses that the exchanger cannot pay directly, and allowing the exchanger to operate the property as if he or she owned it.

Now let's address the question of WHY. Why would anyone go through all of this? There are many situations that might warrant consideration of a reverse exchange. For instance, we have structured reverse exchanges for land owners who purchased property at an auction and needed to close within a short time frame. In other cases, investors have come across a deal that they did not want to miss, but the sellers were not willing to wait for the investors' old properties to sell. In yet another situation, the sale of the investor's old property fell apart at the last minute and he stood to lose the new property if he did not close on it. One last scenario involves peace of mind - investors sometimes take their time finding just the right deal. When that deal is found, they ask us to structure a reverse exchange. They might then put several properties on the market for sale, any one of which could function as their relinquished property should it sell. For some folks, it's actually an easier way to execute an exchange than the typical forward exchange because it avoids having to deal with identifying potential replacement properties within the 45-day window that Section 1031 allows. It can allow the investor to locate and secure the perfect property instead of only having the selection of whatever is on the market during the time of the exchange.

The information in this article describes a reverse exchange within the Safe Harbor provided by the IRS within Rev. Proc. 2002-37 and subsequent rulings. It is not intended to be comprehensive, but to provide an overview for a basic understanding of the reverse exchange process. Reverse exchanges are more expensive for the investor than a standard exchange, primarily due to the additional expense that the intermediary must incur to establish the single-purpose entity, the tax-reporting requirements for that entity, and so forth. Reverse exchange fees can be several times that of fees for a standard exchange. The rules for reverse exchanges are also used when a taxpayer wishes to construct a new building or make improvements to an existing one using exchange funds.

To conclude, reverse exchanges are an exchange structure that is increasingly popular. In the right situations, reverse exchanges can be extremely advantageous. Should you have any questions about reverse exchanges, please feel free to contact us.