Reverse Exchanges:
Do I have to sell something before I can do a 1031 exchange?
By Kathryn Clampitt, CES®, Vice President - Austin, TX
The popular belief is that a property owner must first sell their relinquished property prior to purchasing replacement property as part of a tax deferred exchange. While this is the most common sequence of events, there are a number of situations that warrant acquiring replacement property and “parking” ownership of such property with an accommodating party prior to actually selling the relinquished property—a “Reverse Exchange.” Effectively completing a reverse exchange requires the services of a skilled accommodator familiar with the many tax and legal issues raised by these types of exchanges.
The initial hurdle in completing a reverse exchange requires ensuring that the party acquiring title to the replacement property be respected as the actual owner of the property for tax purposes, and not the agent of the taxpayer/exchanger. If the titleholder of the parked property is not respected as its true owner, the exchanger will be treated as the owner of the parked property, and will not be able to exchange into the parked property, since a taxpayer cannot exchange into property they already own. For many years, 1031 and exchangers utilized various legal formats to effectively “park” ownership of property with the accommodator to enable the exchangers to later acquire the property in an exchange. All of these parking arrangements bore various legal risks. However, on September 15, 2000, the IRS issued Revenue Procedure 2000-37, which provided a safe harbor procedure to allow exchangers to engage in reverse exchanges without fear of an IRS challenge that the taxpayer was inappropriately in title to the parked property.
Under the safe harbor, exchangers are allowed to park ownership of property with an accommodating party—referred to as the Exchange Accommodation Titleholder—for a period of up to 180 days, after which time the parked property must be transferred to the exchanger or to a third party purchase. Within 45 days of parking a property, the exchanger must also identify in writing which of their properties they will be selling as relinquished property. While the safe harbor allows exchangers to park ownership of both replacement and relinquished properties, this article will focus only on the parking of replacement property, which is the more common of the two structures.
To accomplish the parking of a replacement property under the safe harbor, the accommodator, or a related company will typically form a new single member limited liability company or other business entity, commonly referred to as a “special purpose entity” (SPE) to acquire title to the parked property. This SPE then acquires the parked property with either cash borrowed from the exchanger, bank financing guaranteed by the exchanger, or a combination of the two. The SPE then “parks,” or holds on to the title of the replacement property until the exchanger has sold their relinquished property and is ready to complete an exchange—up to a maximum of 180 days. The SPE and the exchanger will typically enter into various agreements during the parking period, such as leasing the parked property to the exchanger or third parties, executing purchase and/or option agreements allowing the exchanger to purchase the parked property, etc. Once the relinquished property is sold to a third party buyer, the exchanger engages in a typical exchange transaction, using their net sale proceeds to purchase the parked property from the SPE, thereby completing the reverse exchange.
In any real estate market experiencing price appreciation, a reverse exchange can be a very powerful tool—saving taxes on the sale of the relinquished property, and potentially saving thousands of dollars on the purchase price of the parked property. However, due to the strict timelines which must be adhered to, the need to often work closely with lending institutions financing the acquisition of the parked property, and the many legal and tax issues that can arise while the replacement property is parked, reverse exchanges should only be engaged in with the assistance of a qualified intermediary experienced in handling such matters.
Our staff of Certified Exchange Specialists®(CES®), CPAs, and attorneys has many years of experience structuring reverse exchanges both within and outside the safe harbors described above. If you have additional questions on how a reverse exchange might benefit you, please contact your nearest branch of Summit Accommodators (see inset at left for contact numbers).
Our web page on reverse exchanges
Kathryn Clampitt, Vice President of Summit 1031 Exchange in Austin, has over 16 years of experience in business accounting, real estate and 1031 exchange facilitation. Kathryn received her Certified Exchange Specialist® designation in 2003. Contact Kathryn at 1.877.877.1031 or kclampitt@summit1031.com
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