Overview of Reverse Exchanges

Internal Revenue Code Section 1031 and Regulations issued by the Internal Revenue Service ("IRS") in 1991 provided investors with a detailed "safe harbor" procedure to exchange real property and defer payment of capital gains taxes.  Under the 1991 Regulations, title to the property the investor desires to exchange (the "Relinquished Property") must be conveyed before the investor receives title to the property the investor desires to acquire (the "Replacement Property").  In the 1991 Regulations, the IRS specifically excluded "Reverse Exchanges" from the "safe harbor" provisions; that is, transactions where the investor conveys title to the Relinquished Property after acquiring title to the Replacement Property.

It was not until September 15, 2000 that the IRS issued safe harbor guidelines for Reverse Exchanges (Rev. Proc. 2000-37) which specify the procedures and conditions under which the IRS will not challenge the exchange because title to the Replacement Property is acquired prior to the conveyance of title to the Relinquished Property. This safe harbor provides a way for an investor who is faced with a situation where it is necessary to acquire the Replacement Property before the Relinquished Property is sold to accomplish an exchange under Section 1031 with a minimal amount of tax risk.

Structure of a Safe Harbor Reverse Exchange

Using the funds from the investor or a third party lender, the EAT acquires title to the Replacement Property under the terms of a sale and purchase contract negotiated by the investor. The EAT "warehouses" the Replacement Property until the investor arranges for the sale of the Relinquished Property, which is then sold under the terms of a sale and purchase contract negotiated by the investor. Thereafter, the property held by the EAT is sold to the investor as the Replacement Property in the exchange, and the investor or other lender is repaid the funds loaned to the EAT to the extent of the funds realized from the sale of the Relinquished Property.

The funding of the Replacement Property acquisition can be structured in several ways. The funds for the purchase may be cash advanced to the EAT by the investor and secured by the Replacement Property, or from financing provided by a third party lender to the EAT and secured by the Replacement Property and/or the Relinquished Property, or a combination of such sources. The Reverse Exchange safe harbor guidelines provide that the investor may guarantee the obligations of the EAT to a third party lender.

The Reverse Exchange safe harbor guidelines provide that the Replacement Property may be leased by the EAT to the investor during the period of time that the EAT holds title. By leasing the Replacement Property under a "triple net" lease, the investor has the full use and enjoyment of the Replacement Property and has the right to all rents and other income from the property, and is required to insure and maintain the property and pay all expenses of the property. The investor may also supervise the making of improvements to the Replacement Property while it is held by the EAT, and act as a contractor to make such improvements.

Accomplishing a Reverse Exchange requires solving certain problems that are different for each transaction. For example, some mortgage lenders will not lend funds to an exchange accommodator to acquire and hold title to the Replacement Property. Therefore, often other sources of financing must be found to acquire the Replacement Property, such as "carry-back" financing from the seller, or a short term portfolio loan from an institutional lender.

Reverse Exchanges Outside the Safe Harbor

Notably, the Reverse Exchange safe harbor guidelines provide they are not the exclusive way to accomplish a Reverse Exchange which qualifies for tax deferred treatment under Section 1031. However, investors considering a Reverse Exchange that does not comply with the safe harbor guidelines should note that there is little authority that directly supports tax-deferral treatment for such a transaction. To date the I.R.S. has looked favorably on Title Holding Exchanges outside of the Reverse Exchange safe harbor guidelines. However, investors should appreciate the risks in engaging in a Title Holding Exchange that does not comply with the Reverse Exchange safe harbor guidelines, and consult with their tax advisor before deciding to engage in this type of exchange transaction.

Qualified Intermediary Services for Reverse Exchanges

National 1031 Exchange Service, LLC, has assisted many investors in the reverse exchange of their properties both within and outside of the safe harbor guidelines. National 1031 Exchange Service, LLC has been very successful solving problems that arise in reverse exchanges, including assisting investors in arranging financing with institutional lenders to acquire Replacement Property to be held by an EAT.