Real estate investors interested in enjoying the tax benefits of a like-kind exchange may consider a “reverse exchange.” In a reverse exchange, the replacement property is acquired before the investor transfers the relinquished property. While the tax code does not allow an exchanger to exchange into a property already owned, a reverse exchange allows an exchanger to secure the replacement property prior to the sale of the original property. These transactions are more complex than a standard 1031 exchange and come with certain advantages and disadvantages.

Reverse Exchanges
There are two versions of reverse exchanges, each with its own rules:

Exchange-First Transaction. An exchange accommodation titleholder (EAT) purchases the relinquished property from the investor, with funds lent by the investor, before closing on the replacement property. A qualified intermediary (QI) uses the proceeds to acquire the replacement property. The EAT holds title to the relinquished property until the investor sells it to a third party.

Exchange-Last Transaction. The EAT purchases the replacement property with the investor’s funds.  When the taxpayer has a contract to sell the relinquished property, a QI sells it to the buyer and uses the proceeds to purchase the replacement property from the EAT. At closing, the EAT receives the proceeds, which it uses to pay off the loan to the investor.

With each version, time frames must be met to satisfy IRS “safe harbor” rules.

Pros and Cons
The principal benefit of the exchange-first structure is that it eliminates the need for the EAT’s participation in the financing process for the replacement property. If, however, there is existing financing secured by the relinquished property, the lender may have a right to approve the transfer to the EAT. Another drawback is the possibility of underestimating the sales price, which could lead to taxable excess proceeds.

With an exchange-last transaction, the investor can borrow the funds it expects to get from the relinquished property and pay down the loan after the relinquished property closes, but before taking title to the replacement property. This allows the investor to invest all of the exchange funds in the replacement property and defer all taxes. On the other hand, the EAT will need to sign loan documents if the investor borrows money secured by the replacement property, and the loan must be nonrecourse to the EAT. The investor may need to personally guarantee the loan.

Get the Big Picture
If you are considering an exchange, weigh the cost of potential environmental factors, taxes, closing costs and similar issues. Your real estate and tax advisors can help you decide if you should pursue a reverse exchange.

If you would like additional information or have questions about whether a reverse exchange is right for you, please contact Anita Wescott at [email protected].