We will continue to discuss 1031 exchanges given the far-reaching potential these transactions can have for real estate owners. A successful exchange can defer any amount of accumulated capital gains – even millions! – and so investors can literally “borrow” these funds to acquire a better-performing replacement property. As we’ve discussed before, exchanges are shrouded in rules and regulations; this is just one reason why investors need a well-trained facilitator when they conduct an exchange. Furthermore, exchanges also come in different variations; there isn’t just one structure, but actually numerous structures that can be used.
In this post, we’re going to provide a basic overview of the “reverse” exchange. This type of exchange is becoming increasingly popular among investors for several reasons.
Reverse Exchanges – An Approved Structure
Readers should recall that the standard or most common type of 1031 exchange is the so-called “delayed” exchange. This exchange follows the classical structure of selling first and buying second. In a delayed exchange, the taxpayer sells his or her property – the “relinquished” property – and then acquires another property to complete the exchange. A reverse exchange means that the order of these transactions is flipped, and so a taxpayer buys a replacement property first and then sells his or her property afterward.
The rules of 1031 exchanges forbid a person from owning the replacement property and the relinquished property at the same time. Readers may wonder: how can reverse exchanges be allowed if taxpayers cannot own both properties simultaneously? The answer is that taxpayers need to “park” the replacement property with the facilitator to make this happen.
Parking Arrangements and QEAAS
The facilitator plays a more involved role in a reverse exchange. In a reverse, the facilitator will hold the replacement property in its own entity or will create a single-member LLC to hold the property, and then transfer the property to the taxpayer after the taxpayer sells the relinquished property. This bit of maneuvering allows the taxpayer to accomplish a reverse exchange without violating the simultaneous ownership rule. This arrangement is referred to as a “parking” arrangement in 1031 lingo because the facilitator temporarily “parks” the property for the taxpayer.
A reverse exchange also requires the creation and execution of a specialized contract called a “qualified exchange accommodation agreement,” or QEAA. The QEAA contains all the terms which make the reverse exchange viable. Among other things, the QEAA outlines the financing conditions, details on parking arrangements, liability issues, and so forth. The taxpayer needs to provide up-front financing in a reverse exchange, and this is another point on which these exchanges differ from traditional delayed exchanges.
Reverse Exchanges Come in Different Variations
Another point which readers should know is that reverse exchanges actually come in several different variations. An “exchange-first” reverse exchange involves the parking of the relinquished property, followed by the acquisition of the replacement property (by the taxpayer), followed by the sale of the relinquished property to a new buyer. An “exchange-last” reverse exchange is the more common structure and involves the parking of the replacement property. The replacement property is parked, and then the taxpayer arranges for the sale of the relinquished property. This is then followed by the transfer of the replacement property to the taxpayer.
Importantly, reverse exchanges still abide by the 180-day timeline. This is spelled out in Revenue Procedure 2000-37, which is the IRS’ official guideline on the structure of reverse exchanges.