Taxpayers can use a reverse exchange to avoid the biggest issue they may face in a §1031 exchange: finding suitable replacement property in the short 45-day identification period after closing on the sale of the relinquished property. By allowing a taxpayer to close on the acquisition of the replacement property before closing on the sale of the relinquished property, a reverse exchange provides welcome flexibility.

The authority for reverse exchanges is found in Revenue Procedure 2000-37, later amended by Revenue Procedure 2004-51. The approved structure involves a “Qualified Exchange Accommodation Arrangement” in which an “Exchange Accommodation Titleholder” (EAT) acquires legal title to either the replacement property or the relinquished property until the relinquished property can be sold to a third party. The EAT is usually a limited liability company owned by the qualified intermediary hired to facilitate the exchange. By “parking” title to one of the properties with the EAT, the taxpayer avoids owning both properties at the same time, which would preclude a §1031 exchange.

While it is generally easier to park the replacement property with the EAT, in certain circumstances that may not be possible. For instance, the lender for the replacement property may not approve of the EAT being the owner and borrower, especially at the last minute when the loan has been underwritten and is ready to close. In those instances, parking the relinquished property with the EAT may be the only option.

Structure

While there are often variations, the basics of parking the relinquished property (also known as an “exchange first” reverse exchange) are as follows.

Step 1: Acquire the replacement property

  1. The taxpayer finds the ideal replacement property. The seller insists on closing quickly, yet the relinquished property has not been sold. The parties enter into a contract of sale.
  2. At least one to two weeks prior to closing on the replacement property, the taxpayer or their attorney contacts a qualified intermediary, who sets up the EAT. The parties enter into a Qualified Exchange Accommodation Arrangement Agreement (QEAA), under which the EAT will purchase the relinquished property from the taxpayer. If an actual buyer has not yet been found, the purchase price is estimated and paid through a combination of the assumption of the existing mortgage and carryback financing provided by the taxpayer to the EAT, documented by a promissory note.
  3. The taxpayer enters into an exchange agreement with the qualified intermediary and assigns the benefits of the QEAA, as well as the benefits of the replacement property contract, to the qualified intermediary.
  4. At closing, the taxpayer conveys title of the relinquished property to the EAT and pays the balance of the purchase price to the qualified intermediary in return for the EAT’s promissory note.
  5. The qualified intermediary pays the seller of the replacement property the funds it received from the taxpayer. The lender also pays the mortgage proceeds to the seller, who then conveys title of the replacement property directly to the taxpayer.

At this point the acquisition side of the exchange is complete: the relinquished property has been sold to the EAT, and the taxpayer has received the replacement property. The EAT may also lease the relinquished property to the exchanger, so the exchanger has use and occupancy during the exchange period and bears the cost of all maintenance, repairs, utilities and other property-related expenses.

Step 2: Sell the relinquished property

  1. The relinquished property still needs to be sold by the EAT to a third party within the 180-day exchange period. Once a buyer is found, the EAT enters into a contract of sale.
  2. At closing, the EAT conveys the relinquished property to the buyer, and the sales proceeds are used to pay off both the outstanding mortgage assumed by the EAT and the EAT’s promissory note to the taxpayer.

Considerations

As mentioned, parking the relinquished property is generally more complicated than parking the replacement property, because the transaction is not completed until the relinquished property is actually sold to a third party. The actual sale price may be higher or lower than the price estimated at the start of the exchange. The taxpayer may also not have sufficient funds to match their equity in the relinquished property, requiring them to borrow more when they acquire the replacement property. In either event, the difference in equity could result in the taxpayer receiving “boot” when the relinquished property is sold, which would be subject to taxation. Parking the relinquished property therefore works best when the replacement property acquisition is all cash or low leverage. Regardless of which property is parked, depending on the jurisdiction, duplicate transfer tax and closing fees may need to be addressed.

Given the complexity of reverse exchange transactions, advance planning and timing are essential. Taxpayers should consult with their tax advisors and a knowledgeable qualified intermediary as early in the process as possible.