If an exchanger has identified a property they wish to purchase, but finding a buyer for the property they’re selling is taking longer than expected, they should consider a Reverse Exchange.
Property owners looking to defer taxes through a 1031 Exchange need to be mindful of the real estate market when considering their strategy and timeline. In a busy market like the one we saw in early 2022, exchangers may find it easier to sell their relinquished properties, but have to prepare for the difficulty in identifying a replacement property within the 45-day window.
As with all things, there are ebbs and flows, and any frenzied market is likely to slow. In a down market, it might be harder to know when your relinquished property will sell. In cases where the closing date of a sale is more difficult to predict, a Reverse Exchange can allow you to secure the replacement property before you find a buyer for your relinquished property.
How a Reverse Exchange works
If you’re familiar at all with Section 1031, it’s likely in the form of a Deferred Exchange, where the sale of the relinquished property is completed first. The sale proceeds are held by the Qualified Intermediary, and the exchanger has 45 days to identify replacement properties and 180 days to complete their acquisition(s). This timeline gives exchangers a safe harbor within which to complete their exchange without challenge by the IRS.
But what if you’ve already identified your replacement property before completing the sale of the relinquished property? Perhaps you haven’t yet found a buyer for the relinquished property, or perhaps you have a buyer, but can’t be sure of the closing date. In those cases, you have the option of a Reverse Exchange.
A Reverse Exchange is where the replacement property is acquired first and held by an Exchange Accommodation Titleholder (EAT) until the “exchange” can be completed. You then have the same 45 days to identify and 180 days to complete the transaction as you do with a Deferred Exchange, but they apply to the relinquished property. So long as you follow the IRS’s “Safe Harbor” guidelines in Revenue Procedures 2000-37 and 2004-51, the exchange will still qualify for tax deferral.
These IRS guidelines include:
1. An agreement must be entered into between the exchanger and an EAT within 5 days of the EAT taking title to the property to be parked.
2. The combined time frame that the relinquished property and the replacement property are held in a Parking Arrangement cannot exceed 180 days.
3. Identification of the relinquished property must be made no later than 45 days after the EAT acquires the title to the parked replacement property.
If you fail to identify the relinquished property within 45 days or complete the sale within 180 days, your exchange will fall outside of the safe harbor and may be subject to challenge by the IRS. But for those who successfully follow these rules, a Reverse Exchange allows them to move ahead with an acquisition without waiting for the sale of their relinquished property to be completed, offering greater flexibility in an uncertain market.
Additional Benefits of a Reverse Exchange
There are certain scenarios where Reverse Exchanges provide even more flexibility. One of these is a Build to Suit (BTS) arrangement. Often used by operating companies looking to continue their operations while a new facility is developed, this is where an exchanger will park the new property with the EAT and act as a construction manager to oversee the development of the new space while continuing operations in their old location. When the new space is ready for occupancy, the exchanger can seamlessly transition from the old location to the newly-completed location without any downtime.
In a BTS scenario, the occupant is able to specify how the building should be designed to meet their business needs, making this ideal for restaurants, coffee shops, and other brands that have particular design specifications. This is useful because it not only allows the exchanger to develop exactly what they need, but also allows the exchanger to include some of the improvement costs into the adjusted basis and maximize the amount of tax that is deferred.
How to do a Reverse Exchange right
By their very nature, Reverse Exchanges are more complicated than Deferred Exchanges. While a Deferred Exchange requires a Qualified Intermediary, not all QIs have the necessary experience or appetite to facilitate Reverse Exchanges. As the industry’s leading experts in these types of exchanges, JTC can provide the necessary tools, including:
1. A special purpose entity (such as an LLC) to act as the EAT and acquire a qualified indicia of ownership in the property to be parked.
2. A QI to serve as the exchange facilitator.
3. Documentation for both the exchange and parking transactions.
4. Legal agreements for leasing or construction management.
5. A Qualified Escrow or Qualified Trust to hold the proceeds from the sale of the relinquished property, if necessary.
6. Assistance with timely notifications of parking and exchange deadlines.
7. Digital archiving of executed exchange documentation.
If you or your clients wish to perform a 1031 Exchange but are unsure of how to proceed in the current real estate market, talk to a JTC representative today. Our experienced team has the expertise to make even the most complex exchange scenarios easier to understand, manage, and complete successfully.
Learn more about JTC’s Qualified Intermediary services by downloading our 1031 Exchange Solution Sheet.