Exchange-First Reverse Exchanges

February 19, 2020

Reverse 1031 exchanges are complex transactions. These transactions stand up under judicial scrutiny, such as in the case of Bartell. The IRS has also stepped in and tried to provide guidance for taxpayers wishing to perform these transactions. Although they are complex, they can offer advantages to taxpayers. And, in some cases, taxpayers need to conduct these transactions in order to acquire a specific property. To avoid costly litigation, taxpayers should follow the guidelines given by the IRS. The principal document of concern here is Revenue Procedure 2000-37. This document imposes a time window on these transactions, and also several other requirements.  

Two Variations

There are two variations of reverse exchanges, the exchange-first and the exchange-last. The exchange-last transaction is by far the most common. This is the variation involving parking of replacement property by the intermediary or third party. The exchange-first variation involves the parking of the relinquished property. In this post, we will discuss the mechanics of the exchange-first variation in detail and highlight the reasons why this transaction tends to be uncommon. Before conducting this type of transaction, taxpayers should always seek out guidance from a highly experienced tax attorney. Exchange-first transactions are usually quite complex, and can present numerous legal issues. Taxpayers need to consult with a qualified tax attorney in order to avoid potential litigation. 

Mechanics of Exchange-First Reverse Exchanges 

First, let’s go over the mechanics of the more common exchange-last reverse exchange. In this transaction, target replacement property is acquired first. That happens even before the sale of the relinquished property. The target replacement property is “parked” by the intermediary. Usually, this means that the intermediary establishes a single member LLC to take title to the replacement property. While the taxpayer arranges the sale of the relinquished property, the taxpayer leases this property. The taxpayer then immediately receives a deed to the replacement property from the LLC, after the sale of the relinquished property. Completion of the whole transaction must occur within 180 days. Once the intermediaty obtains the replacement property, the relinquished property must be sold within 180 days. This is directly from Rev. Proc. 2000-37. It mirrors the delayed exchange requirements from the Treasury Regulations.  

In the exchange-first reverse exchange, the relinquished property is parked, rather than the replacement property. It is parked with the intermediary. A single member LLC is typically set up for this . Then, the taxpayer directly acquires the replacement property. This is allowable, because technically the taxpayer has “disposed” of the relinquished property by parking it with the intermediary. Then, completing the transaction, an outside party purchases the relinquished property. The buyer then obtains the relinquished property directly from the intermediary. As with exchange-last transactions, this transaction also must be completed within 180 days.  

Mirroring the exchange-last transaction, in the exchange-first, the intermediary leases the relinquished property back to the taxpayer after it is transferred. This enables the taxpayer to continue generating income from the property and operating the property as before.  

Exchange-First Reverse Exchanges are the Least Common 

There are a number of reasons why the exchange-first reverse exchange is the least common reverse transaction. For one, a particular confluence of events has to be present to make these transactions optimal. The taxpayer typically needs to have a buyer lined up to purchase the relinquished property at the start of the transaction. The taxpayer also needs to have a target replacement property acquired prior to the sale of the relinquished property. Intermediaries do not like to take title to the relinquished property (via the LLC, or “exchange accommodation titleholder,” EAT) unless there’s a guaranteed buyer. This is to avoid any chance of the relinquished property failing to close.  

What’s more, taxpayers have to find an intermediary which is willing to perform this transaction. Exchange-first reverse exchanges are quite complex, and not every intermediary is willing to conduct them. These transactions very often present difficult financing issues and so only some intermediaries offer this service. This variation is also typically more expensive than the alternative, exchange-last reverse exchange.  

Exchange-First Transactions Require Expert Counsel 

As with exchange-last reverse exchanges, the taxpayer must sign a specialized contract with an intermediary to perform this type of transaction. This specialized contract is a Qualified Exchange Accommodation Agreement, or QEAA. The contract authorizes the intermediary to function as the “buyer” and “seller” of the various properties involved in the exchange. Even if a given exchange-first transaction appears to be relatively straightforward, taxpayers should always seek expert counsel before performing one. Taxpayers need to procure the services of a tax attorney who has thoroughly studied the various authoritative documents which apply. An experienced tax attorney will be able to spot potential legal issues and provide advice in order to avoid litigation in the future.  

Call Us for Assistance

The attorneys at Mackay, Caswell & Callahan, P.C., work hard to help their clients solve the various tax and debt related issues which come their way. Complex 1031 exchanges can be intimidating for taxpayers. These transactions are complex, and clients can face very stiff penalties. Section 1031 exchanges are just one area in which we have expertise. Whether it’s a 1031 exchange, OIC or debt consolidation, MCC strives for excellence in every case it handles. If you have a tax issue, contact one of our top New York City tax attorneys today for immediate assistance. 

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