An Intro to Reverse 1031 Exchanges
Section 1031 like-kind exchanges have come up on our blog multiple times in the recent past. This isn’t surprising: Section 1031 can be an extremely powerful wealth maximization tool, and it figured prominently as a matter of debate in the most recent series of tax code revisions. Fortunately for taxpayers, the real estate provision of Section 1031 survived the revisions, and so real estate investors can still take advantage of Section 1031’s tax deferral benefits. Just like reorganizations under Section 368, like-kind exchanges under Section 1031 have several variations; one variation is the “reverse” like-kind exchange. Reverse 1031 exchanges are a bit more complex than traditional “forward” 1031 exchanges which involve acquiring the replacement property after the relinquished property has already been sold. With reverse exchanges, the replacement property is acquired first, and then the relinquished property is sold after this acquisition.
In this article, we will cover in detail the mechanics of the reverse 1031 exchange process and then we will highlight some of the advantages conferred on investors by this type of transaction. As you’ll see, although these transactions are typically much more expensive than traditional forward exchanges, they may be preferable in certain cases depending on facts and circumstances.
Reverse 1031 Exchange Mechanics
With the implementation of the Treasury Regulations under subsection (k), the structure of forward exchanges was firmly established. However, uncertainty lingered as to the precise structural requirements governing so-called “reverse” exchanges. In Revenue Procedure 2000-37, the IRS provided a “safe harbor” for reverse transactions by laying out a number of structural guidelines.
Under Rev. Proc. 2000-37, for example, taxpayers have 180 days to sell their relinquished property after their target replacement property is acquired. However, the replacement property cannot be acquired directly by them, because that would involve holding title to both properties simultaneously. To structure the reverse exchange, the taxpayer should engage a qualified intermediary, a “QI” (or third party facilitator) to “park” title to the replacement property through the use of a single member LLC. In this scenario, the single member LLC is referred to as an “exchange accommodation titleholder” or EAT. So, the QI or third party facilitator established an EAT which parks title to the desired replacement property, and then the taxpayer has a total of 180 days to sell their property. Importantly, the taxpayer must sign a Qualified Exchange Accommodation Agreement – or QEAA – with the EAT in order to create a valid parking arrangement.
It’s worth noting that Rev. Proc. 2000-37 only guarantees that the taxpayer won’t be challenged on the acceptability of the exchange so long as the taxpayer stays within the procedure’s structural boundaries. Taxpayers can structure reverse exchanges outside of these boundaries, but doing so will put them in a “gray zone” and leave them vulnerable to possible challenges by the IRS. Fortunately, however, there is case law which supports reverse exchanges structured outside of the guidelines of 2000-37. No matter what the situation, you should always consult with a 1031 professional before attempting to structure a reverse 1031 exchange because a failed exchange can result in heavy penalties and interest.
Reverse 1031 Advantages
Given the complexity of reverse 1031 exchanges, you may be wondering why any taxpayer would wish to conduct such a transaction. Reverse 1031 exchanges are generally much more expensive than traditional exchanges – sometimes more than 10 times the cost – and so it’s easy to question whether such transactions are worth the additional cost and effort. One of the most important advantages of reverse exchanges is timing. The motivation behind most reverse exchanges had to do with the availability of the replacement property: typically, the taxpayer is focused on acquiring a specific piece of real estate, but either doesn’t have a contract to sell his or her own property at that time, or the contract to sell his or her property is set to be executed at a time when the replacement property will be off the market. In either scenario, it’s clear that the taxpayer would need to structure a reverse exchange in order to acquire the replacement property he or she desires.
Let’s use a quick example to illustrate this point. Suppose a taxpayer wishes to utilize Section 1031 and procures a contract to sell his or her property. Let’s further suppose that the contract is concluded in the middle of March and has an execution date of May 15th. At the outset, the taxpayer doesn’t have any reason to back out of this contractual agreement because he or she hasn’t found any suitable replacement properties. However, let’s also suppose that, in the middle of April, the taxpayer finds the perfect replacement property, but that property is a hot commodity and will need to be acquired immediately otherwise it will certainly be unavailable by May 15th. This is the classic scenario in which a reverse like-kind exchange would need to be used to acquire the replacement property.
One of the other main benefits of reverse 1031 exchanges is the (effective) removal of the “identification requirement.” Under the regulations, taxpayers must properly “identify” replacement property before they acquire it. There is an exception to this general rule – when the replacement property is received within 45 days, then the property is considered to be identified automatically – but taxpayers will still be counseled to identify their replacement property in nearly all cases. In a reverse 1031 exchange, this step is completed from the outset because the replacement property is acquired first.
This is just an introduction. There’s plenty more to reverse 1031 like-kind exchanges, and in the future we will dive back in and explore more of the complex issues associated with these transactions. If you need counsel with a reverse 1031 exchange, traditional forward exchange, or any other tax issue, you should reach out to Mackay, Caswell & Callahan, P.C. and chat with a top NYC tax attorney. Our attorneys are very well-versed in Section 1031 exchanges as well as many other complex tax areas. We would be delighted to use our expertise to help you with your transaction!
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