The Reverse Exchange
A reverse exchange is the “flip side” of a deferred (delayed) exchange. In a reverse exchange the Exchanger
for various reasons must acquire their like-kind replacement property before disposing of a relinquished property.
Until recently it was unclear whether reverse exchanges would be given nonrecognition treatment by the IRS.
However, on September 15, 2000, that question was answered by the IRS in the form of Revenue Procedure 2000-37
(“Rev. Proc. 2000-37”). This Revenue Procedure provides that tax deferral on reverse exchanges will be recognized
if the transactions fall within the scope of an announced IRC §1031 “safe harbor.” The new reverse exchange rules
can be expected to lead to two categories of reverse exchanges, those that fit neatly within the safe harbor
guidelines and those that do not fit within the safe harbor rules.
The “Safe Harbor” Reverse Exchange
In a reverse exchange structured under the safe harbor protection of Rev. Proc. 2000-37 the entity used to
facilitate a reverse exchange is referred to as the Exchange Accommodation Titleholder (“EAT”), and the property
held by the EAT is commonly called the “parked property”. The EAT will usually form a special purpose entity
(the “Holding Entity”) to take title to the parked property. To complete a reverse exchange the Holding Entity
can take title to either the relinquished property or the replacement property under a “Qualified Exchange
Accommodation Arrangement”. The document between the Exchanger, EAT and the Holding Entity is termed the
“Qualified Exchange Accommodation Agreement” (“QEAA”).
Under Rev. Proc. 2000-37, a safe harbor reverse exchange must be completed within 180 days after the Holding
Entity acquires the parked property. The durational limit on safe harbor transactions is taken from those of a
delayed exchange, which by statute must be completed within the lesser of 180 days or the due date of the Exchanger’s
tax return for the year in which the relinquished property is transferred. Additionally, under a safe harbor
reverse exchange the Exchanger must identify one or more relinquished properties within 45 days after the Holding
Entity acquires the replacement property. Rev. Proc. 2000-37 adopts the same identification rules that apply in
delayed exchanges, which require written identification be delivered to another party to the exchange, such as the
Holding Entity, EAT or the Qualified Intermediary, and limits the number of alternative and multiple properties
that can be identified.
The “Non-Safe Harbor” Reverse Exchange
Under Section 3.02 of Rev. Proc. 2000-37 which specifically states, “the Service recognizes that ”parking“
transactions can be accomplished outside of the safe harbor provided in this revenue procedure”, Rev. Proc. 2000-37
leaves open the option for some aggressive Exchangers to structure a reverse exchange that does not comply with all
of the provisions of the Revenue Procedure and, therefore, Exchangers may elect to pursue reverse exchange structures
that will take longer than 180 days or which will not have identified relinquished property. Since there is no
regulatory authority to assist in structuring a reverse exchange outside the parameters of the safe harbor there is
a much higher risk associated with such exchanges and, therefore, non-safe harbor reverse exchanges should be
attempted only if there is an absolute need to proceed outside of Rev. Proc. 2000-37.
Experts in the field agree that unlike under Rev. Proc. 2000-37, a valid non-safe harbor exchange will require the
Holding Entity to undertake more responsibility for ownership of the parked property than just bare tax ownership. Most
tax experts believe that Holding Entities operating outside of the safe harbor of Rev. Proc. 2000-37 will need to be
the owner of the parked property for both tax and financial reporting purposes, thus showing the assets and liabilities
associated with the parked property on its books for GAAP purposes. As a result of this potentially adverse impact on
the financial statements of the publicly traded parent corporation of most large Qualified Intermediaries, these
Qualified Intermediaries, including IPXI031, will not be allowed to participate in non-safe reverse exchanges. While
IPXI031 cannot assist clients with non-safe harbor reverse exchanges by acting as the Holding Entity, IPXI031 can still
participate in the exchange as the Qualified Intermediary working in conjunction with the Exchanger’s tax counsel and
non-safe harbor Holding Entity.
The Procedure - Parking the Replacement Property
In the most common type of reverse exchange the Exchanger contracts with the Holding Entity to have it purchase
and retain title to the replacement property. In the first phase of the reverse exchange the Exchanger loans the
necessary down payment funds to the Holding Entity, who in turn uses these funds along with funds provided by a
third-party lender, if any, to close on the replacement property and take title in the Holding Entity’s name. Under
the terms of the parking agreement or the QEAA, the Holding Entity leases the property to the Exchanger under a triple
net lease. In this way the Exchanger can begin to use the property or sublet the property while the Holding Entity is
on title. On the rare occasion that a lease agreement is not possible the Holding Entity may be willing to retain the
Exchanger or a third party designated by the Exchanger as the property manager. The use of a property management
agreement instead of a triple net lease adds substantial tax reporting obligations to the reverse exchange structure
and, therefore, this type of arrangement should not be used unless other more suitable options are unavailable.
When the Exchanger sells the relinquished property identified in the exchange it is transferred directly to the
buyer through a simultaneous exchange with the Qualified Intermediary and the use of direct deeding. The cash proceeds
of the sale go to the Qualified Intermediary, who uses the proceeds to acquire the replacement property from the
Holding Entity. The Holding Entity uses these proceeds from the sale to first repay the loan from the Exchanger and
then any additional proceeds are used to pay down the third-party loan on the replacement property prior to deeding
the replacement property to the Exchanger. If there are more proceeds from the relinquished property sale than the
Qualified Intermediary needs to acquire the replacement property, the Qualified Intermediary can use the excess
proceeds to purchase additional replacement property within 180 days of the transfer of the relinquished property,
provided that such additional replacement property can be properly identified by the Exchanger within 45 days of the
close of the relinquished property.
This type of reverse exchange works well when the Exchanger can pay all cash for the replacement property, when
the seller is providing the financing, or when an Exchanger is working with a sophisticated third-party lender. If
a loan from an institutional lender is required, the Exchanger should seek lender approval for this type of exchange
prior to beginning the exchange because the Holding Entity (not the Exchanger) may be required to be the borrower on
the loan as the titleholder of the property. Exchangers should be aware that despite Rev. Proc. 2000-37 many lenders
are not familiar with reverse exchanges, many types of loans are not available when pursuing a reverse exchange and
the loan costs may be increased to cover the lender’s document preparation and legal fees. In a safe harbor exchange
to protect the lender’s security interest and to protect the Holding Entity from liability in the event of a default
by the Exchanger, the Exchanger will guarantee the loan and the Holding Entity will only be the borrower on a
non-recourse loan and deed of trust or mortgage.
The Procedure - Parking the Relinquished Property
An alternative to parking the replacement property is to have the Holding Entity park the Exchanger’s relinquished
property. This type of reverse exchange begins with a simultaneous exchange involving the Exchanger, the Holding
Entity, the seller of the replacement property and the Qualified Intermediary. Here, with the assistance of the
Qualified Intermediary, the Exchanger transfers the relinquished property to the Holding Entity and then simultaneously
receives the replacement property from the seller. Both transfers occur through the Qualified Intermediary and the
use of direct deeding. Since the relinquished property has not yet been sold to a true buyer to provide exchange
funds for the acquisition of the replacement property, the Exchanger must loan the funds to the Holding Entity. The
funds are then put into the exchange through the Qualified Intermediary to be used to acquire the replacement property
from the seller. This loan should equal the equity the Exchanger has in the Relinquished Property. As in the
replacement-parking alternative, the Holding Entity leases the relinquished property to the Exchanger under a triple
net lease agreement. In the second half of the transaction when the Exchanger has located a suitable buyer for the
relinquished property, the relinquished property is sold and deeded from the Holding Entity to the buyer. The cash
proceeds from the sale go to the Holding Entity and are used first to retire any existing third-party debt the Holding
Entity took subject to, and then to repay the Exchanger for the original loan to the Holding Entity. If the price
paid by the Holding Entity for the parked property differs from the actual price paid by the ultimate buyer, the
Exchanger and the Holding Entity will enter into a purchase price adjustment agreement to increase or decrease the
original purchase price and loan amount from the Exchanger as necessary to reflect the final purchase price.
Parking Replacement Versus Relinquished Property
- When dealing with replacement property of a residential nature quite often institutional lenders will not
make the acquisition loan to the Holding Entity even if guaranteed by the Exchanger so the only alternative is
to have the Holding Entity take title to the relinquished property so that the Exchanger can take direct title
to the replacement property with a new loan from the institutional lender.
- To prevent a boot issue and the payment of capital gain taxes on excess proceeds from the sale of the
relinquished property the equity from the relinquished property must be reinvested in the replacement property
prior to the Exchanger taking title. If the estimated proceeds from the relinquished property are greater than
the funds available for the down payment on the replacement property, the Exchanger may wish to have the Holding
Entity take title to the replacement property so that the Holding Entity has an opportunity to use the excess
funds from the sale of the relinquished property to pay down the debt on the replacement property prior to
transferring title to the Exchanger, or the Exchanger can try to acquire additional replacement property at the
time the relinquished property is sold and the 45-day identification period and 180-day exchange period start
to run. If the Holding Entity is taking title to the relinquished property the down payment on the replacement
property should equal or exceed the estimated equity in the relinquished property to avoid boot.
- Parking the relinquished property can be risky since the Exchanger must be careful not to trigger a due-on
sale clause in the relinquished property loan when the relinquished property is deeded to the Holding Entity.
- Often the Exchanger does not know which relinquished property will be used in the exchange, or which
relinquished property will sell first. In this situation, it is advisable for the replacement property to be
parked with the Holding Entity to allow the Exchanger the opportunity to tie up the replacement property until
the Exchanger knows which relinquished property to use in the exchange or which one will sell first.
Practical Considerations
- To fall within the safe harbor protection of Rev. Proc. 2000-37, the Exchanger must identify the relinquished
property to be exchanged within 45 days of the Holding Entity taking title to the parked replacement property, and
the Holding Entity cannot remain on title for longer than 180 days.
- During the time the Holding Entity is on title to the property the Holding Entity will require hazard and
commercial general liability insurance, an acceptable recent Phase I Environmental Site Assessment Report and an
indemnity from any liability from the Exchanger.