What is a Reverse Exchange and What Causes it to Fail?
A conventional IRC §1031 tax deferred exchange involves, among other things, a taxpayer’s sale of old property (the “relinquished property”) followed by the purchase of new property (the “replacement property”) within a 180 day period. A so-called reverse exchange takes place when the taxpayer is forced to acquire the replacement property, or face losing it, prior to the sale of the relinquished property. The sequence of the disposition and acquisition is “reverse” from the conventional transaction. There are special IRS rules that provide a “safe harbor” to accomplish a reverse exchange. The technique is much more complicated than a conventional exchange and pricier too. But many people enter into such transactions because the benefit far outweighs the complexities and higher cost.
The reverse exchange rules require the taxpayer to sell the relinquished property within 180 days of the facilitator’s acquisition of the replacement property on behalf of the taxpayer. On occasion, the taxpayer, for a variety of reasons, is unable to get the relinquished property sold within that time frame. Without further structuring, the transaction will fail at the end of 180 days. Not only does the taxpayer lose the time, effort and costs, but more importantly, the treatment of the new property as the replacement property for the sale of the old property is lost. The taxpayer simply owns the replacement property directly and not as a part of an exchange.
What is a White Knight and How does it Rescue the Failing Reverse Exchange?
As explained above, the inherent problem is that the taxpayer is unable to find a buyer within the 180 day time frame. However should the taxpayer be able to find an accommodating party to buy the property, as a favor to the taxpayer, to enable him or her to recognize a sale within the applicable time period that is treated the same as a sale to a “real” buyer. The accommodating party can be a friend, family member or other relative.
Isn’t a Related Party Prohibited from Doing an Exchange with the Taxpayer?
Some family members are defined as “related parties” (such as lineal descendants) while some are not so defined (such as aunts/uncles, nephew/niece, in-laws). So the accommodating party may be a family member that is not deemed a related party, however this technique should still work even if the party is a related party. While the “Related Party” provisions contained in the rules do generally prevent a taxpayer purchasing replacement property from a related party, those rules do not prohibit selling relinquished property to a related party. Essentially sales to a related party can result in a basis shift that the IRS considers “abuse” of the rules. Basically it is like “gaming the system”. But a purchase of relinquished property does not result in the same type of basis shifting. It is generally not considered a problem in an exchange context.
So How Exactly Does this Work?
Simple. Just like the proverbial White Knight riding in at the last minute to rescue the damsel in distress, in the exchange context, the friendly party’s purchase of the property from the taxpayer just prior to the expiration of the 180 day period, allows the taxpayer to meet the necessary time deadlines. The friendly party can continue to market the property for sale and once sold, no matter how long it takes, everyone is made whole using the proceeds from the sale to the true buyer.
What are the Options on Financing the Purchase from the Taxpayer?
This is not quite as simple. This can be accomplished in a number of different ways. The friendly party can take the property subject to any underlying mortgage against the property (be cognizant of any due on transfer clause in the mortgage) and can pay cash for the balance. Alternatively, the balance can be financed by the taxpayer so that the friendly party does not have to come up with cash personally.
Reverse exchanges are begun with the taxpayer retaining the services of an exchange company to acquire and hold the replacement property for the taxpayer per the reverse exchange rules. It is quite common that the taxpayer provides, through a loan to the exchange company, for the funds needed for the exchange company to acquire the property. In most exchange transactions, when money from the sale of the relinquished property flows through the exchange process, those proceeds are cycled through and are used to repay the taxpayer’s original acquisition financing.
In addition to having financed the exchange company’s original purchase of the replacement property, in this White Knight scenario, as mentioned above, the taxpayer also often finances the friendly party’s acquisition of the relinquished property. In that case, the buyer’s note gets cycled through the process and ends up going back to the taxpayer, just as cash would in a typical reverse exchange, to pay off the taxpayer’s acquisition financing. When the dust settles, the taxpayer made his or her necessary deadlines, owns the replacement property and holds a note on the sale of the relinquished property to the friendly party. Whenever the friendly party is able to sell the property to a true buyer, any underlying mortgage is paid off and what is left goes back to the taxpayer to pay off the note held by the taxpayer.
A recent transaction which took place in our office should provide further clarification of the process.
A Recent Case Study
In the spring of this year a client called seeking reverse exchange service. The client was buying a small strip center for $1,250,000. The relinquished property, a commercial condominium unit valued at $500,000, was listed for sale but not under contract at the time of the replacement property closing. The client lent the exchange company $1,250,000 to cover its purchase of the replacement property (sometimes a bank may make all or part of these loans). Nearing the end of the 180-day period, it became clear that the relinquished property would not be under contract, or closed, within the necessary time frame.
The client prevailed on his father-in-law to purchase the condominium unit. There was a $250,000 mortgage in place, so the relative took title subject to the mortgage balance and the client took back a note for $250,000 for the balance of the purchase price. Alternatively, the father in law could have paid $250,000 in cash, but that was not the facts here. The sale of the relinquished property took place within 180 days of the acquisition of the replacement property and the client adhered to all necessary time frames.
Several months later, a third-party buyer was found for the property and paid $500,000 for it. The father-in-law was the nominal seller. The first $250,000 went to retire the underlying mortgage and the other $250,000 went to repay the client loan to the relative.