Reverse 1031 Exchange
What is a Reverse 1031 Exchange?
A “reverse” exchange occurs when the taxpayer acquires the replacement property before transferring the relinquished property. A “pure” reverse exchange, where the taxpayer owns both the relinquished and replacement properties at the same time, is not permitted. The IRS has provided guidance on structuring a reverse exchange, offering a safe harbor under Rev. Proc. 2000-37. An Exchange Accommodation Titleholder (EAT), acquires and holds the target property (the parked property) in a separate special purpose entity, typically a single member LLC (the EAT and LLC are jointly referred to as “EAT”). To complete a reverse exchange, the EAT will take title to either the Relinquished Property or the Replacement Property under a “Qualified Exchange Accommodation Arrangement” (QEAA).
Reverse 1031 Exchange Time Periods
The same 45 day Identification Period and 180 day Exchange Period deadlines of IRC §1031 apply to a safe harbor reverse exchange under Rev. Proc. 2000-37, with a slight tweak. If the EAT has begun the exchange by acquiring the Replacement Property, then the Exchanger must identify within 45 days after the EAT’s acquisition of the parked property, one or more Relinquished Properties to be exchanged for the Replacement Property. The identification rules require that written identification be delivered to another party to the exchange, such as the EAT or the Qualified Intermediary, identification permitted under the three property or 200% rules.. The identified Relinquished Property must be sold, and the parked Replacement Property transferred to the Exchanger to complete the exchange within 180 days of parking the Replacement Property with the EAT.
Important Timing Considerations
The time deadlines for reverse like-kind exchanges, as outlined in Revenue Procedure 2000-37, parallel the deferred exchange time deadlines of IRC §1031. Failure to meet the 45 day and 180 day time deadlines does not disqualify the transaction, but the Exchanger will not enjoy the benefit of the presumptions available under the safe harbor.
- Day 45 Deadline: On or before midnight on the 45th day after the EAT acquires the parked property, the Exchanger must unambiguously identify, in writing, the potential relinquished properties for the exchange.
- Day 180 Deadline: On or before the 180th day after the EAT acquired the parked property, the EAT must transfer either a parked replacement property to the Exchanger, or a parked relinquished property to a third party buyer.
It is important to remember that the 180 day parking period outlined in Revenue Procedure 2000-37 and the 180 day exchange period of IRC §1031 work independently of one another. The Exchanger must satisfy the requirements of both to to ensure compliance with the IRS requirements.
Like Kind Property in a Reverse Exchange
The “like-kind” property requirement of IRC §1031 also applies to reverse and improvement exchanges. To qualify for an exchange the Exchanger’s relinquished and replacement properties must be property that has been and will be held either for productive use in a trade or business or for investment. All real estate in the United States is considered like-kind to all other U.S. real estate, but it must also be held for a proper purpose to qualify under §1031. In an improvement exchange only materials actually in place and labor actually performed prior to the Exchanger taking title to the replacement property will qualify as like-kind property. Exchange funds cannot be used to prepay for materials or labor.
Revenue Procedure 2000-37 Creates A Safe Harbor
With the issuance of Revenue Procedure 2000-37 the IRS formally recognized the use of a reverse exchange structure. If the parking arrangement falls within its guidelines, the presumption is that the Exchange Accommodation Titleholder (“EAT”) is the legal owner of the parked property, not the Exchanger.
Parking arrangements are also useful when the Exchanger wants to use exchange funds to improve the replacement property. Since exchange funds cannot be used to improve property the Exchanger already owns, a parking arrangement can be structured to enable an EAT to take title to the replacement property. The exchange funds are loaned to the EAT, who pays the vendors directly. At the end of the exchange period the Exchanger acquires the replacement property, whose value has been increased by the improvements.
Permissible Safe Harbor Arrangements
Revenue Procedure 2000-37 provides Exchangers with great latitude in structuring the transaction. It does not require that the Exchanger and the EAT deal with each other on an arm’s length basis for several types of legal and contractual arrangements. Included on this safe harbor list are arrangements that allow: (1) the Exchanger to loan funds to the EAT, even if the loan does not bear interest; (2)the Exchanger can guaranty funds loaned by a third-party to the EAT; (3) the parked property can be leased to the Exchanger for use or occupancy without paying the EAT a market rent; (4) the Exchanger can control and manage the construction of improvements on the parked property, or even act as general contractor; (5) the Exchanger can guaranty the obligations of the EAT to third parties and indemnify the EAT for any losses; (6) the Qualified Exchange Accommodation Agreement can contain “puts” and “calls” that allow the Exchanger to take the parked property from the EAT at a fixed price, or can provide for an adjustment in the agreed upon value of the relinquished property, should that property sell to the ultimate buyer at a different price; and (7) the EAT to also act as the Qualified Intermediary in the exchange transaction.
Parking Structures for Reverse and Improvement Exchanges
There are four main structures for parking arrangements. Three of the four structures require the EAT to step into the place of the Exchanger and acquire title to the replacement property. The fourth variation has the EAT acquire title to the relinquished property from the Exchanger. All four structures along with detailed descriptions can be found here.