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Reverse Exchanges: Save and Make Money

Real estate investors can significantly benefit from 1031 exchanges. They can continue to increase the value of their real estate while deferring their taxable gains. But what about the investors that gain rental income from their properties?
Reverse Exchanges Save and Make Money renting or buying property

During the 180-day window it takes to complete a forward 1031 exchange, they may lose half of their yearly earnings by first selling their current property and then looking for their replacement, the usual order of events in a forward exchange. A reverse exchange, where the replacement property is acquired before the replacement property is sold, can not only save the exchanger money but allow them to profit even more throughout the exchange process.

The IRS does not allow a taxpayer/exchanger to hold title or ownership to both the replacement and relinquished property simultaneously. They will let an Accommodator, usually an affiliate company of the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary (QI) hold the new property title for you until you can sell your old one. Having an Accommodator hold the title of your property is called "parking a property”, since title to the property is placed in the name of the Accommodator. Your Accommodator can take actual title to the property do this by way of a single-member LLC owned by it that is explicitly opened for your exchange. This LLC is called an Exchange Accommodation Titleholder, more commonly referred to as an EAT, and does what it says: it holds the title - nothing more. The property is then leased from the EAT, also the QI, to the taxpayer/exchanger. The EAT allows the investor to have full access to the new replacement property, also allowing access to profits from the new property right away.  Let's use an example to break down a reverse exchange and its benefits:

A commercial real estate investor owns an apartment building with a market value of $3.2 million and yields a monthly rental income of $15,000 This investor wants to upgrade their investment and purchase an office building for $5.3 million, which generates a monthly $25,000 in rental income. The investor enters into a contract to acquire the office building. 

This situation is where we encounter a problem. The investor has already identified the replacement property they would like to purchase and entered into a contract to purchase. Still, they have not sold the apartment building nor begun a forward exchange. If the investor holds ownership of those properties simultaneously, they can no longer transact a tax-deferred exchange. This investor does not want to lose the opportunity of a new office building by waiting until the apartment building is sold, nor can they afford to lose the monthly rental earnings from the apartment building by following the timeline of a forward exchange. Therein lies the problem for some investors when considering a forward exchange.

The investor consults with their legal and tax advisors on what to do and decides to move forward with a 1031 reverse exchange. The commercial investor coordinates with their qualified intermediary and begins the process. The qualified intermediary opens an LLC for the exchange. This LLC will be the Also referred to as an "EAT", is typically a special purpose, limited-liability company that is used to own the legal title to property that is being parked as part of a reverse exchange. An exchange accommodation titleholder may not be a disqualified person. Exchange Accommodation Titleholder , which will hold the title for the office building while the investor sells the apartment building. The creation of the LLC costs the investor about $500, and they now have full access to the office building and can begin to receive the $25,000 in monthly rental income. All while still receiving the $15,000 from the apartment building. Once the office building has been parked, the investor has 45 days to identify which property they will be selling, and the specified property is the apartment building. After the 45 days, the investor has the remaining 135 days of the initial 180 days to sell the property and finalize the exchange. The investor finds a buyer and completes the sale of the apartment building four months later. 


This is the breakdown of their costs:

  • Office Building Rent …………………………………………. ($25,000 X 4) $100,000
  • Apartment Building Rent…………………………………. ($15,000 X 4) $60,000
  • Creation of LLC…………………………………………………. -$500
  • Exchange Fees…………………………………………………. -$7,000


The investor makes a total of $152,500 in rental income after subtracting the cost of the LLC and exchange fees. At the end of the 180 days, the proceeds from the sale are used to transfer the title from the EAT to the investor, and the exchange is finalized. The investor in this example would have sold the apartment building in a forward exchange and then looked for the replacement property, costing him those four months of rental income from either property.

A common question is, how will the EAT pay for the new property? The answer is a simple. The EAT relies on the exchanger. But this does not need to be an area for concern. Under applicable rules the exchanger can enable the purchase the new property with cash or use a lender. If an exchanger uses  a lender, it must be willing to have the EAT sign the security instrument for the loan, as it will be the new property owner. Since the EAT will be the party in title on the property, it would have to sign the Deed of Trust/ A debt instrument that is secured by real estate collateral that the borrower is obligated to pay back over a period of time with a predetermined set of payments, which include both the loan and interest. Mortgage to secure the loan for the lender.  It would typically sign the Note as well.  It is customary for the taxpayer to sign any personal guaranty for the loan. The loan is essentially non-recourse to the borrower with all recourse going to the taxpayer. The taxpayer must also prepare to add the EAT to the insurance of the parked property.

Finally, how can the exchanger feel sure that the EAT will not sell their property to someone else while selling their old property? Part of the term that the IRS coined in the "reverse exchange" Rev. Proc. 2000-39 on the overarching agreement, which must be put in place between the EAT and the taxpayer, is a purchase option. The purchase option is part of a " This is a term that the IRS coined in the “reverse exchange” Rev. Proc. 2000-39 pertaining to the overarching agreement which must be put in place between the Exchange Accommodation Titleholder and the taxpayer. The Rev. Proc. contains certain provisions which are mandatory to be in the agreement in order for these parking arrangements to be in the safe harbor set forth in the Rev. Proc. This applies to reverse exchanges of relinquished or replacement property as well as build-to-suit and property improvement exchanges. Qualified Exchange Accommodation Agreement ," the legal document allowing an exchanger and the EAT to move into a parking arrangement. The purchase option gives the exchanger the exclusive right to buy the EAT replacement property, precisely what the exchanger will do right after selling. After the taxpayer sells the old, relinquished property, the EAT will use the proceeds to pay the taxpayer what they owe them and then give the asset's title to them. On limited occasion the taxpayer will be unable to sell the old property within the 180 day time limit, in which case the parked property is simply transferred directly to the taxpayer.

Accruit’s team of experts are available to help answer questions, work through your 1031 exchange concerns, and facilitate exchanges in cases where it is advantageous. Contact Accruit by phone – 800-237-1031 or visit accruit.com today! 


 

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