In a "Buyer's" market, flexibility is key. If you find a property you would like to acquire before you sell your current property, a Reverse 1031 Exchange can save you thousands of dollars in capital gains tax.
Since the IRS gave the green light to reverse exchanges in Rev Proc 2000-37, taxpayers have been exercising new abilities in tax deferral, even when that perfect replacement property must close prior to the close of the sale property. Reverse exchanges are significantly more complex and require the assistance and planning of your own CPA, but in some circumstances, they are just what the doctor ordered.
For Emphasis: You need your CPA/Tax Attorney's opinion that a Reverse Exchange is in your best interest prior to putting one in place.
Compare it to driving your car in reverse, using only your rear view mirrors to navigate. You would certainly use more care and focus to accomplish it.
In a "safe harbor" so-called Reverse Exchange, the taxpayer locates the property it wants to acquire as its Replacement Property. The taxpayer will first enter into a purchase contract to buy the new property. It will then enter into an Exchange Agreement with the Qualified Intermediary (QI), with an underlying agreement with an Exchange Accommodation Titleholder (or "EAT"), formed by the QI expressly for the reverse exchange and assign the purchase contract to the EAT.
The EAT becomes the contract purchaser for the new property. The taxpayer and the EAT enter into a "Qualified Exchange Accommodation Agreement" in which the EAT agrees that, if the taxpayer (and/or some third-party lender) loans the amount of proceeds expected to result from the sale of the old property to the EAT, the EAT will use the funds to purchase the new property.
Just like a normal 1031 Exchange, the proceeds from the sale of the Relinquished Property must be used to acquire the Replacement Property. For this to be possible the Exchanger must be able to produce those funds from another source and use them to purchase the Replacement Property.
The exchanger must loan the EAT LLC formed by the Qualified Intermediary expressly for their Reverse Exchange the amount of proceeds expected to result from the sale of the Relinquished Property. The exchanger will be repaid from the Proceeds when the Relinquished Property is sold. If the amount of proceeds from the Relinquished Property exceeds the amount loaned to purchase the Replacement Property, the difference could be taxable, unless a delayed exchange is performed with the balance. Another replacement property must be identified and purchased. If you suspect this might happen, it would be wise to spell it all out as to percentages in the Exchange Agreement in the beginning.
In any reverse exchange, the Exchange Accommodation Titleholder, or EAT, MUST acquire title to the replacement property
first, before the taxpayer can acquire it. At some point during the exchange period there must be a "straight-up swap" between the taxpayer and the relinquished property, and the EAT and the replacement property. When the swap takes place at the beginning of the exchange period it is called an "Exchange First" and when it takes place at the end, just prior to the sale of the relinquished property to the true buyer, it is called an "Exchange Last. Let’s explore each scenario briefly:
Which type of Reverse Exchange utilized depends on whether or not the exchanger will be financing the purchase the Replacement Property in the Exchange. In a Reverse 1031 Exchange requiring financing for the purchase of the Replacement Property, the Exchange First will be utilized.
Exchange First
The reason the Exchange First must be utilized when new financing is required for the replacement property is that the new lender
will usually refuse to fund a loan to purchase property unless the taxpayer is taking title to it.
1) The Exchanger finds and enters into contract to purchase suitable Replacement Property, inserting Exchange Clause into the contract verbiage.
2) Exchanger must calculate the amount of Proceeds expected from the sale of their Relinquished Property and be able to bring those funds, as a loan, to the closing. The loan is to be repaid within 180 days, when the sale of the Relinquished Property
closes. In our example the sale price is $2mil, the mortgage is $750,000.00, and let’s say $150,000.00 in costs will be paid by the Exchanger, so the proceeds should be in the neighborhood of $1.1mil. In our example the Exchanger chooses use personal savings as well as take out an equity line on his primary home to generate the $1,100,000.00.
3) The Exchanger makes arrangements for financing as normal (i.e. Exchanger shops around and applies for a mortgage.) In applying for the mortgage the Exchanger in this example will be using the $1.1 mil as a down payment on the Replacement Property.
4) The Exchanger completes "Due Diligence" with regard to the Replacement Property.
5) The Exchanger makes arrangement with Haven Exchange for a Reverse Exchange. Haven Exchange creates the EAT LLC in the same state as the Replacement Property.
6) At closing The EAT LLC does a double escrow; one in which the LLC acquires the replacement property from the seller, the "straight-up swap", and the EAT LLC executes a Note borrowing the $1.1mil from the Exchanger in order to acquire the Replacement Property, and simultaneously conveys the Replacement Property to the Exchanger in exchange for the Relinquished Property. This is the escrow to be funded by the exchanger’s new lender.
7) The Relinquished Property is leased to the exchanger by the EAT LLC so that the taxpayer may continue to manage it to produce income until,
8) It is sold within the following 180 days. The Proceeds from that sale are used to pay off the Note owed by the LLC to the Exchanger. This completes the Reverse Exchange. When the Exchanger receives the amount of the Proceeds as loan repayment it is not a taxable occurrence.
Exchange Last
In a "safe harbor" so-called Reverse Exchange, the taxpayer locates the property it wants to acquire as its Replacement Property. The taxpayer will first enter into a purchase contract to buy the new property. It will then enter into an Exchange Agreement with the Qualified Intermediary (QI), with an underlying agreement with an Exchange Accommodation Titleholder (or "EAT"), formed by the QI expressly for the reverse exchange and assign the purchase contract to the EAT.
The EAT becomes the contract purchaser for the new property. The taxpayer and the EAT enter into a "Qualified Exchange Accommodation Agreement" in which the EAT agrees that, if the taxpayer (and/or some third-party lender) loans the amount of proceeds expected to result from the sale of the old property to the EAT, the EAT will use the funds to purchase the new property. The EAT will then lease the property to the taxpayer on a ‘net lease’ basis, for a nominal lease payment. Then, when the taxpayer has sold the old property, the EAT will transfer the new property to the taxpayer at the price which the EAT paid for the new property, and in exchange for the old property. When the old property closes, the proceeds are used to repay the sum loaned to the EAT for the purchase of the new property. This completes the taxpayer’s exchange and is not a taxable event, but loan repayment.
The taxpayer has the benefit of getting the immediate use of the new property, without any interruption in its business activities. The taxpayer has the added benefit of selling its old property in a manner which brings the best price. This is the essence of a "safe harbor" Reverse Exchange. The basic criteria are that the taxpayer and the EAT must enter into a written agreement which sets forth their rights and obligations.
When, within the 180 day period, the relinquished property is sold, but prior to the close of escrow, the exchanger and EAT swap the replacement for the relinquished property. The EAT is amended into the escrow as seller. At the close of escrow, the proceeds go to the EAT, which uses them to repay the Note to the exchanger for the funds loaned originally to purchase the replacement property. There has been no taxable event and the exchange is over.
Call Haven Exchange, Your Expert Source for 1031 Solutions. We'll help you pull it off.
(866) 794-1031.
Our Reverse Exchange program, designed by our Attorney, N. Brooke Gabrielson, is the most thoroughly correct program we have encountered in the industry. The reason we make that statement is that we continually run into resistance from the escrow officer, who tells us that our competition never takes title to the properties, never does the swap escrow to end up on title to the relinquished property. We hope they are never audited, because it is our understanding that if the EAT does not first acquire title to the replacement property, and then swap it for the relinquished property with the exchanger, those exchanges could be disallowed.
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