<h2 aria-level="1" paraeid="{f9d25216-1388-4fb4-b80a-f2e651cca622}{193}" paraid="635633104" role="heading">Evolution&nbsp;</h2>

<p paraeid="{f9d25216-1388-4fb4-b80a-f2e651cca622}{209}" paraid="1334361355">The idea that an exchange of a like kind property for another should not subject a Taxpayer, or Exchanger, to a tax payment so long as they did not “cash out” formed the basis for Section 1031 to become part of the Tax Code in 1921. At one time almost all asset types could be exchanged, but in the present era, only real estate can be exchanged. The rationale for this tax deferral was based on the fact that the Exchanger maintained a “continuity of investment” in the asset, and it would be unfair to assess a tax under the circumstances of maintaining the investment in the “like kind” property. Then, as well as now, applicable taxes were deferred until some final cash out disposition, if any.&nbsp;</p>

<p paraeid="{f9d25216-1388-4fb4-b80a-f2e651cca622}{219}" paraid="1925776512">There were additions to the Code section over time but there were still a lot of open questions as the use of §1031 gathered steam over the years. In 1991, the IRS sought to provide more certainty on what could or could not be done and promulgated some regulations to provide a safe harbor that people could follow when entering into a tax deferred exchange. The 1991<a href="/sites/default/files/Internal%20Revenue%20Service%20Regulations%20IRC%20Section.pdf"> regulations</a> included distinct safe harbors:&nbsp;&nbsp;</p>

<ul role="list">
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="1" data-font="Symbol" data-leveltext="" data-list-defn-props="{&quot;335552541&quot;:1,&quot;335559685&quot;:720,&quot;335559991&quot;:360,&quot;469769226&quot;:&quot;Symbol&quot;,&quot;469769242&quot;:[8226],&quot;469777803&quot;:&quot;left&quot;,&quot;469777804&quot;:&quot;&quot;,&quot;469777815&quot;:&quot;multilevel&quot;}" data-listid="3" role="listitem">
<p paraeid="{f9d25216-1388-4fb4-b80a-f2e651cca622}{230}" paraid="615793731">Security or Guaranty Arrangements&nbsp;</p>
</li>
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="2" data-font="Symbol" data-leveltext="" data-list-defn-props="{&quot;335552541&quot;:1,&quot;335559685&quot;:720,&quot;335559991&quot;:360,&quot;469769226&quot;:&quot;Symbol&quot;,&quot;469769242&quot;:[8226],&quot;469777803&quot;:&quot;left&quot;,&quot;469777804&quot;:&quot;&quot;,&quot;469777815&quot;:&quot;multilevel&quot;}" data-listid="3" role="listitem">
<p paraeid="{f9d25216-1388-4fb4-b80a-f2e651cca622}{237}" paraid="850104611">Qualified Escrow and Qualified Trust Accounts&nbsp;</p>
</li>
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="3" data-font="Symbol" data-leveltext="" data-list-defn-props="{&quot;335552541&quot;:1,&quot;335559685&quot;:720,&quot;335559991&quot;:360,&quot;469769226&quot;:&quot;Symbol&quot;,&quot;469769242&quot;:[8226],&quot;469777803&quot;:&quot;left&quot;,&quot;469777804&quot;:&quot;&quot;,&quot;469777815&quot;:&quot;multilevel&quot;}" data-listid="3" role="listitem">
<p paraeid="{f9d25216-1388-4fb4-b80a-f2e651cca622}{244}" paraid="2062269065">Use of Qualified Intermediaries&nbsp;</p>
</li>
<li aria-setsize="-1" data-aria-level="1" data-aria-posinset="4" data-font="Symbol" data-leveltext="" data-list-defn-props="{&quot;335552541&quot;:1,&quot;335559685&quot;:720,&quot;335559991&quot;:360,&quot;469769226&quot;:&quot;Symbol&quot;,&quot;469769242&quot;:[8226],&quot;469777803&quot;:&quot;left&quot;,&quot;469777804&quot;:&quot;&quot;,&quot;469777815&quot;:&quot;multilevel&quot;}" data-listid="3" role="listitem">
<p paraeid="{f9d25216-1388-4fb4-b80a-f2e651cca622}{251}" paraid="1549766104">Interest and Growth Factors&nbsp;</p>
</li>
</ul>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{7}" paraid="1444167837">During a comment period before the 1991 rules came into effect, many people wrote in to the Internal Revenue Service (IRS) asking if the final rules could provide some guidance when circumstances dictated that the Replacement Property needed to be acquired before the sale of the Relinquished Property, commonly referred to as a Reverse Exchange, or when a portion of the Relinquished Property sale proceeds needed to be allocated to construction or improvement on the new property, a Construction or Improvement exchange. The IRS replied to these comments by declining to include such guidance but indicated that it would continue to study the issue and provide rules on it in the future. It took some time, but in the year 2000, that guidance was published in <a href="/sites/default/files/Rev%20Proc%202000-37_0.pdf" title="Revenue Procedure 200-37 pertaining to 1031 Exchanges">Revenue Procedure 2000-37</a>.</p>

<h2 paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{18}" paraid="853233036">Safe Harbor for Reverse and Improvement Exchanges&nbsp;</h2>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{24}" paraid="1575481572">Like the Forward Exchange Rules before it, IRS Rev. Proc. 2000-37 provided a new safe harbor for Reverse and Construction/Improvement Exchanges. Among other things, the rules required having a third party, referred to as an Exchange Accommodation Titleholder, park title to the subject property as part of the necessary structure. Also, it was a condition of the safe harbor that the transaction, including the title parking arrangement, could go on no longer than 180 days.&nbsp;</p>

<h2 paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{30}" paraid="547767587">Traditional Structuring for Reverse and Improvement Exchange Prior to the Safe Harbor&nbsp;</h2>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{48}" paraid="500590676">Prior to the issuance of this Rev. Proc. in 2000, there was some case law on Reverse and Property Improvement Exchanges. The gist of which was that it could be done via a title parking arrangement, but it was necessary for the third-party parking Accommodator to have true “benefits and burdens” of ownership. This was a very high bar to reach and required such things as:&nbsp;</p>

<ul role="list">
<li aria-setsize="-1" data-aria-level="2" data-aria-posinset="1" data-font="Arial" data-leveltext="•" data-list-defn-props="{&quot;335552541&quot;:1,&quot;335559685&quot;:1440,&quot;335559991&quot;:360,&quot;469769226&quot;:&quot;Arial&quot;,&quot;469769242&quot;:[9675],&quot;469777803&quot;:&quot;left&quot;,&quot;469777804&quot;:&quot;•&quot;,&quot;469777815&quot;:&quot;hybridMultilevel&quot;}" data-listid="2" role="listitem">
<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{54}" paraid="1874800697">Risk of gain or loss required should the market value change over the term of the parking arrangement&nbsp;</p>
</li>
<li aria-setsize="-1" data-aria-level="2" data-aria-posinset="2" data-font="Arial" data-leveltext="•" data-list-defn-props="{&quot;335552541&quot;:1,&quot;335559685&quot;:1440,&quot;335559991&quot;:360,&quot;469769226&quot;:&quot;Arial&quot;,&quot;469769242&quot;:[9675],&quot;469777803&quot;:&quot;left&quot;,&quot;469777804&quot;:&quot;•&quot;,&quot;469777815&quot;:&quot;hybridMultilevel&quot;}" data-listid="2" role="listitem">
<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{69}" paraid="580755852">“Skin in the game” from the Accommodator, often thought to be a minimum of 5% of the equity&nbsp;</p>
</li>
<li aria-setsize="-1" data-aria-level="2" data-aria-posinset="3" data-font="Arial" data-leveltext="•" data-list-defn-props="{&quot;335552541&quot;:1,&quot;335559685&quot;:1440,&quot;335559991&quot;:360,&quot;469769226&quot;:&quot;Arial&quot;,&quot;469769242&quot;:[9675],&quot;469777803&quot;:&quot;left&quot;,&quot;469777804&quot;:&quot;•&quot;,&quot;469777815&quot;:&quot;hybridMultilevel&quot;}" data-listid="2" role="listitem">
<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{76}" paraid="662803493">Lease of the property back to the Exchanger during the parking term with true economics and arm’s length dealing&nbsp;</p>
</li>
<li aria-setsize="-1" data-aria-level="2" data-aria-posinset="4" data-font="Arial" data-leveltext="•" data-list-defn-props="{&quot;335552541&quot;:1,&quot;335559685&quot;:1440,&quot;335559991&quot;:360,&quot;469769226&quot;:&quot;Arial&quot;,&quot;469769242&quot;:[9675],&quot;469777803&quot;:&quot;left&quot;,&quot;469777804&quot;:&quot;•&quot;,&quot;469777815&quot;:&quot;hybridMultilevel&quot;}" data-listid="2" role="listitem">
<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{83}" paraid="1291194488">Exchanger could not be the agent of the accommodator&nbsp;</p>
</li>
<li aria-setsize="-1" data-aria-level="2" data-aria-posinset="5" data-font="Arial" data-leveltext="•" data-list-defn-props="{&quot;335552541&quot;:1,&quot;335559685&quot;:1440,&quot;335559991&quot;:360,&quot;469769226&quot;:&quot;Arial&quot;,&quot;469769242&quot;:[9675],&quot;469777803&quot;:&quot;left&quot;,&quot;469777804&quot;:&quot;•&quot;,&quot;469777815&quot;:&quot;hybridMultilevel&quot;}" data-listid="2" role="listitem">
<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{94}" paraid="858433114">Exchanger could not simply provide a blanket guarantee on any bank loan made to the Accommodator for the purchase price and/or cost of improvements&nbsp;</p>
</li>
</ul>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{101}" paraid="1302338142">As can be imagined, meeting these criteria suggested by the case law was hard to do. The 2000 regulations changed most of this and for all intents and purposes just required the Accommodator to be in legal title during the 180 term of the transaction. Simplifying the requirements provided many Exchangers the ability to enter into these parking arrangements without tax risk.&nbsp;</p>

<h2 paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{115}" paraid="554584921">Rev. Proc. Position on Structuring Outside the Safe Harbor&nbsp;</h2>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{123}" paraid="1400913972">The regulations recognized that it was not always possible to have a parking transaction be concluded within 180 days. For example, in the case of new construction or property improvements, it takes time to get architect plans, permits, deal with inclement weather conditions, etc. Taking this into consideration, the Regs included a paragraph suggesting that “no (adverse) inference” was to be made for deals structured outside the safe harbor, specifically it states:&nbsp;</p>

<p style="margin-left: 50px;">“No inference is intended with respect to the federal income tax treatment of arrangements similar to those described in this revenue procedure that were entered into prior to the effective date of this revenue procedure. Further, the Service recognizes that "parking" transactions can be accomplished outside of the safe harbor provided in this revenue procedure. Accordingly, no inference is intended with respect to the federal income tax treatment of "parking" transactions that do not satisfy the terms of the safe harbor provided in this revenue procedure, whether entered into prior to or after the effective date of this revenue procedure.”</p>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{185}" paraid="1615991114">This language was meant to leave the window open for matters that required more than 180 days to accomplish a completed exchange. For transactions that could only be done for a period in excess of 180 days, the only practical way was to resort to the benefits and burdens approach referred to above and, as before, that was difficult to adhere to.&nbsp;</p>

<h2 paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{203}" paraid="1349343978">The Case of Estate of George H. Bartell, Jr. v. Commissioner, 147 T.C. No. 5 (2016)&nbsp;</h2>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{209}" paraid="1320364534">As so many times before, the landscape for these transactions changed once again with the ruling in the Bartell case that was issued in 2016. That case pertained to a taxpayer who structured an exchange involving new construction with a corresponding parking arrangement for 24 months. The actual period ended up being 17 months. Unlike traditional deals outside the safe harbor, it did not have benefits and burdens built in, rather it merely had a third-party Accommodator, referred to by the Court as a “warehousing” entity, hold title during the parking term. Predictably, the IRS challenged the tax reporting since it did not comply with historical requirements for a structure outside the safe harbor. However, the Federal District Court examined some cases on the subject and reached the conclusion that the case law primarily required a third party to be in title to the property during the period of construction.&nbsp;</p>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{219}" paraid="1008717078">This finding by the Court was a radical departure from what practitioners expected and opened up the door to many more parking transactions to be structured following the Bartell model. While the IRS was bound by the decision, it expressed its continuing disagreement with the holding by filing a “non-acquiesce” to the decision, meaning that it did not agree to be bound by it in other cases. This meant that persons in other Federal Districts could not necessarily rely on the case holding as applicable law.&nbsp;</p>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{233}" paraid="1559927500">However, gradually since 2016 real estate investors and business owners have been structuring deals requiring more than 180 days in conformity with the Bartell decision. At this time in 2024, such a matter being done outside the safe harbor is somewhat commonplace and certainly the IRS is aware that it happens. A lot of time has elapsed since the case holding and there is no evidence that the IRS has disallowed this structure since then so it would seem that a parking arrangement that uses an Accommodator but does not require benefits and burdens to that party, is indeed possible.&nbsp;&nbsp;</p>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{239}" paraid="261623910">Like all tax related matters that are not the equivalent of a published safe harbor, it is always recommended to seek advice from your professional advisers to ensure that any perceived tax risk is properly assessed.&nbsp;</p>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{239}" paraid="261623910">&nbsp;</p>

<p paraeid="{530cbd30-0de9-4362-ad54-a65f651a2107}{249}" paraid="1957836207"><em>The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.&nbsp;</em></p>

<h2>Reverse 1031 Exchange Rules</h2>

<p>Under IRS rules for 1031 Exchanges, a taxpayer must sell the old property, the Relinquished Property, prior to acquiring the new property, the Replacement Property. However due to a wide variety of circumstances, a taxpayer is often faced with losing the opportunity to buy the sought after Replacement Property due to a potential closing date prior in time to a sale of the Relinquished Property. At times, the Relinquished Property is already under contract for sale, but the closing date is beyond the date of a Replacement Property acquisition time, or on occasion the Relinquished Property is not even up for sale or under contract yet. In those situations, taxpayers can utilize a Reverse Exchange.</p>

<h2>What is a Reverse Exchange?</h2>

<p>The term “Reverse Exchange” refers to a fact pattern where a taxpayer needs to effectively close on the acquisition of the Replacement property prior to the sale of the Relinquished Property. The funny thing is that the way to accomplish a Reverse Exchange is to restructure it so that it is not “reverse” at all.</p>

<p>In the year 2000, the IRS provided a set of rules providing a “safe harbor” for Reverse Exchanges when following those rules making it so taxpayers can do a Reverse Exchange. The term, safe harbor, basically means that the structuring of such a transaction is pre-approved by the IRS and will not be challenged as to the structure. To better understand a real-life situation in which a Reverse Exchange may be utilized review this <a href="/blog/case-study-reverse-exchange-real-estate-–-parking-replacement-property" title="Reverse Exchange Real-Life Example">Reverse 1031 Exchange example.</a></p>

<h2>Reverse Exchange Process</h2>

<p>Let’s look at how a reverse 1031 exchange works. The solution provided by the IRS is easier than you might imagine. Essentially the rules suggest under a reverse 1031 exchange process, a taxpayer can retain the services of an exchange company to act as an “Accommodator”, known in the regulations as an Exchange Accommodation Titleholder (EAT), to acquire the Replacement Property and hold it on the taxpayer’s behalf. Under these rules, the reverse 1031 exchange timeline provides that a taxpayer then has up to 180 days to sell the Relinquished Property and consummate the exchange for the Replacement Property being held. Since the taxpayer has not literally acquired the Replacement Property before the sale of the Relinquished Property, he has closed in the proper sequence. Perhaps a bit of smoke and mirrors, but who cares…, the technique is provided for by the IRS. Take a look at this <a href="/sites/default/files/files/Real%20Estate%20Exchanges%20-%20Parking%20Replacement%20Property%201.jpg" title="Reverse Exchange Process Diagram">Reverse 1031 Exchange diagram</a>, for a comprehensive visual of the process.</p>

<p>There are several steps to a valid Reverse 1031 Exchange, for a brief overview of these steps r<a href="/blog/infographic-10-steps-reverse-exchange" title="Reverse Exchange Infographic">eview the infographic</a>.</p>

<h2>Financing in a Reverse Exchange</h2>

<p>In every deal, the question of how to finance the reverse 1031 exchange comes up. The Accommodator does not provide the funds for the purchase. That is done either by a loan from the taxpayer to the Accommodator and/or through a bank loan. That loan is paid back once the Relinquished Property is sold and those proceeds become available. Also, during the period where the Replacement Property is held by the Accommodator, it leases the property to the taxpayer effectively allowing the taxpayer to sublease the property to any actual property tenant and to collect and retain the rent. The taxpayer pays the utilities and other expenses per the terms of the lease. At the end of the day, the Accommodator just makes its fee, and all the economics are retained by the taxpayer.</p>

<h2>Cost of a Reverse Exchange</h2>

<p>Cost for a reverse 1031 exchange vary based upon a lot of factors. Such factors include the type of property such as residential, commercial, industrial, etc., the value of the property, and the source of financing, i.e., taxpayer funded, or bank financed. Sometimes there may be also be environmental issues to deal with which can affect cost. Remember, the exchange company is holding title to the property and the above considerations affect the cost.</p>

<h2>Relationship of Reverse Exchange and Forward Exchange</h2>

<p>People tend to be confused between the interplay of the Reverse Exchange and the related forward exchange. They often say, “Why do I need a forward exchange since I am doing (and paying for) a reverse exchange”. The answer is that although these both relate to a single overall transaction, they are separate, but necessary parts, to the whole transaction. As is now crystal clear to you, the reverse is being done to take the Replacement Property out of play and preserve your ability to trade for it. Technically a Reverse 1031 Exchange is not a 1031 exchange at all, better thought of as just a Reverse Exchange. The forward exchange is an actual 1031 Exchange where the Relinquished Property is sold and exchanged for the Replacement Property. Both are needed to complete a successful Reverse Exchange.</p>

<p>The forward exchange is serviced by a Qualified Intermediary pursuant to a different set of IRS rules than those for an Accommodator providing Reverse Exchange services. The Qualified Intermediary can be a single exchange company that is also wearing another hat acting as Accommodator, such as Accruit, or separate companies each providing services for just one type of exchange, but not both.</p>

<p>&nbsp;</p>

<p><em>The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified&nbsp;Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.</em></p>

<p>Download the free step-by-step guide, <a href="https://info.accruit.com/reverse-exchange-whitepaper">Parking the Replacement Property in a Reverse Exchange</a>.</p>

<h2>The Facts</h2>

<p>On May 7, 2014, an attorney from central Illinois contacted us on behalf of his client, Mr. Lodo, who wished to do 1031 Exchange. Mr. Lodo needed to acquire, or risk losing, his desired replacement property, however, he did not have a buyer in place for the sale of his relinquished property. The purchase price for the replacement property was $1,512,000 and the closing was scheduled for June 6, 2014. In a typical tax deferred exchange, the taxpayer sells the relinquished property first and uses the exchange proceeds to acquire the replacement property. When the situation requires the taxpayer to take ownership of the new property prior to the sale of the old property, in a reverse fashion of a standard 1031 Exchange, this is referred to as a Reverse Exchange.</p>

<h2>The Problem</h2>

<p>Mr. Lodo wanted to do an exchange of his old property for the new property but was unable to find a buyer for his old property prior to the scheduled closing of the new property. Unfortunately, the IRS does not recognize the validity of a "pure reverse exchange" where the taxpayer acquires the new property before the sale of the old property.</p>

<h2>The Solution</h2>

<p><img alt="A reverse exchange of commercial property" src="/sites/default/files/files/reverse-exchange-of-real-estate-2.jpg" style="width:400px; height:282px; margin-left:5px; margin-right:5px; float:right" />This is a common conundrum - the inability to sell the old property prior to the date of acquisition of the new property. To address this situation, the IRS issued Revenue Procedure 2000-37 to effectively enable taxpayers to buy before selling. There are several approved solutions, the most common being to arrange for the exchange company to hold title to the new property on behalf of the taxpayer. When the exchange company services a routine exchange, it acts as a Qualified Intermediary (QI); when an exchange company services a reverse exchange, in which it has to take title to a property, it is referred to as an Exchange Accommodation Titleholder (EAT).</p>

<p>The EAT takes title to the new property and "parks," or holds, that title until the taxpayer sells the relinquished property as part of a conventional forward exchange. In this type of reverse exchange, the taxpayer will ultimately acquire the replacement property from the EAT, who acquired it from the original seller.</p>

<p>In Mr. Lodo’s transaction, a financial institution made a loan of $1,100,000 towards the acquisition price of the new property. The loan was made to a new LLC, established specifically to take title to the new property, with the EAT as its sole member. This loan was documented by a note and secured by a mortgage on the property. Mr. Lodo, rather than the EAT, was asked to guaranty the loan. In addition, Mr. Lodo made his own loan to the LLC in the approximate amount of $412,000 to help finance the EAT’s acquisition of the replacement property. The loan was documented with a note and secured with a pledge of the EAT’s membership interest in the LLC. The acquisition of the new property was closed on June 6, 2014 resulting in a maximum safe harbor deadline to complete the Reverse Exchange as of December 2, 2014.</p>

<p>While the replacement property was held by the EAT, Mr. Lodo entered into a contract to sell the relinquished property with a closing date of October 31, 2014. The sale price was $1,425,000. The debt on the old property was $700,000 and that loan was paid directly from the closing, so the net equity amounted to roughly $725,000.&nbsp; Upon closing, the remaining sale proceeds were deposited directly into Mr. Lodo’s Forward Exchange account.&nbsp; Mr. Lodo then directed the QI to transfer the funds from the exchange account to the EAT in order to pay down the two loans that were originally made to the EAT to acquire the new property. The EAT paid off the $412,000 loan from Mr. Lodo and paid down the loan from the financial institution with the remainder of the funds in the exchange account. Mr. Lodo then took ownership of the replacement property subject to the remaining debt.</p>

<h2>The Result</h2>

<p>Mr. Lodo used the Reverse Exchange safe harbor to manage the purchase of the replacement property before the sale of the relinquished property, deferring taxes on the sale of his relinquished property.</p>

<p>Reverse Exchanges, such as Mr. Lodo's transaction detailed above, are typically documented by the following:</p>

<ul>
<li>&nbsp;&nbsp;&nbsp; An exchanger information form</li>
<li>&nbsp;&nbsp;&nbsp; A qualified exchange accommodation agreement (the reverse exchange agreement)</li>
<li>&nbsp;&nbsp;&nbsp; Assignment to the EAT of the purchase agreement between the client and the seller to buy the replacement property</li>
<li>&nbsp;&nbsp;&nbsp; Limited liability company sale agreement to sell the EAT’s membership interest to the client</li>
<li>&nbsp;&nbsp;&nbsp; Non-recourse promissory note documenting taxpayer’s loan to the EAT to purchase the replacement property</li>
<li>&nbsp;&nbsp;&nbsp; Pledge of the exchange company’s membership interest in the title-holding LLC as security for the note</li>
<li>&nbsp;&nbsp;&nbsp; Master lease allowing for the client to enter into tenant leases directly with the tenants</li>
<li>&nbsp;&nbsp;&nbsp; Environmental indemnity agreement</li>
</ul>

<p>&nbsp;</p>

<p><em>Updated 2/28/2022.</em></p>

<p>While Reverse Exchanges have been safe-guarded since 2000 there is still much confusion in the marketplace&nbsp;as to whether or not they are approved by the IRS. Let's revisit the article below in which we cover frequently asked questions about Reverse Exchanges and discuss the history and evolution of them.&nbsp;&nbsp;</p>

<p>Real estate owners often receive conflicting advice about whether reverse tax deferred exchanges are legitimate tax strategies pre-approved as to structure by the IRS.&nbsp; In fact, reverse tax deferred exchanges have a long history and continue to be a valuable tool for owners of real estate who hold property for investment or business purposes. Here are some of the questions that frequently come up and speak to the evolution of how reverse exchanges of real estate came to be approved. We'll close this post with a look at the two approved structures in place today.</p>

<h2>What is a 1031 Reverse Exchange?</h2>

<p>A reverse exchange refers to the sequence of a taxpayer’s sale of relinquished property and the purchase of replacement property.&nbsp; When circumstances require a taxpayer to acquire replacement property prior to the sale of relinquished property, that situation is known generally as a “reverse exchange” fact pattern.&nbsp; Without further planning, the taxpayer’s direct purchase of the replacement property prior to the sale of the relinquished property, sometimes referred to as a “pure reverse” exchange is not approved by the IRS.&nbsp; The ability to do a reverse exchange requires a taxpayer to structure the transaction in a manner providing for the taxpayer to sell the relinquished property before acquiring the replacement property.&nbsp; In fact, the use of the term “reverse exchange” is a bit of a misnomer since the solution to deal with a reverse exchange fact pattern requires the sequence of sale and purchase to be accomplished with non-reverse timing.&nbsp; There are a couple of ways that this can be accomplished.</p>

<h2>Do the Internal Revenue Service Regulations: IRC§1031 Allow for Reverse Exchanges?</h2>

<p>Not specifically. After the landmark legal decision in the Starker case&nbsp;and the <a href="/exchange-library/internal-revenue-service-regulations-irc-%C2%A71031">1991 Treasury Regulations</a> that followed, exchanges became a lot easier to complete and therefore much more popular than before.&nbsp; For the same reasons, the desire for taxpayers to complete reverse exchanges became much more popular at the same time.&nbsp; In fact, during the comment period between May of 1990 and April of 1991 regarding the proposed regulations governing conventional forward exchanges (see <a href="/exchange-library/internal-revenue-service-regulations-irc-%C2%A71031">Internal Revenue Service Regulations: IRC§1031</a>), many persons requested the IRS to include guidelines for completing a reverse exchange at the same time.&nbsp; In the preamble to those final regulations, however, the Treasury Department declined to do so stating:&nbsp;</p>

<blockquote>
<p>“After reviewing the comments and the applicable law, the Service has determined that the deferred exchange rules of Section 1031(a)(3) do not apply to reverse-Starker transactions… however the Service will continue to study the applicability of the general rule of 1031(a)(1) to these transactions.”</p>
</blockquote>

<h2>Does the IRS Revenue Procedure 2000-37 Allow for Reverse Exchanges?</h2>

<p>Yes. During the period from 1991 through 2000, many professional advisors structured reverse exchanges without the benefit of a “safe harbor” set forth by the IRS.&nbsp; Fortunately, this uncertainty became clarified in September of 2000 with the issuance of <a href="/exchange-library/rev-proc-2000-37-reverse-exchanges">Revenue Procedure 2000-37</a> (Rev. Proc.).&nbsp; Basically, the Rev. Proc. suggested that an accommodating party could acquire the replacement property on behalf of the taxpayer and hold it for up to 180 days (shorter in some cases) allowing the taxpayer time to sell the relinquished property and immediately acquire the replacement property from the accommodating party.&nbsp; Alternatively, the taxpayer could arrange for an accommodating party to acquire the relinquished property from the taxpayer, allowing the taxpayer to immediately acquire the replacement property...provided however, that the taxpayer found a bona fide buyer to acquire the property from the accommodator within 180 days (shorter in some cases).&nbsp; Either of these steps would allow the taxpayer to effectively acquire the new property prior to the sale of the old property through an IRS approved reverse exchange structure.&nbsp;</p>

<h2>What is an EAT in a Reverse Exchange?</h2>

<p>The Rev. Proc. referred to the accommodating party as an “Exchange Accommodation Titleholder”, which is currently often referred to as an “EAT”.&nbsp; There are many companies that provide conventional forward exchange services (as a qualified intermediary) and a more limited number of those companies are also set up to provide EAT services.&nbsp; The practice of holding title to a property on behalf of a taxpayer is often referred to as “parking” title to the property with the EAT.&nbsp; For the mutual benefit of the taxpayer and the EAT, it is customary for the EAT to take title to the property using a special purpose entity, usually a limited liability company (“LLC”).&nbsp; This insulates each separate client’s reverse exchange that is being facilitated by the EAT from other clients’ transactions and from the affairs of the exchange company acting as the member of the EAT.</p>

<h2>Today's IRS Approved Reverse Exchange Structures</h2>

<h3>1. Parking the Replacement Property</h3>

<p>The reverse exchange Rev. Proc. requires the taxpayer and EAT to enter into an overarching document referred to as a Qualified Exchange Accommodation Agreement (“QEAA”) describing the transaction, the relationship between the parties and reciting certain required terms.&nbsp;</p>

<ul>
<li>Usually the taxpayer will already be under contract with the buyer prior to contacting the EAT in regard to the reverse exchange.&nbsp; To shift the purchase over to the EAT, there is a simple assignment document assigning the purchase contract from the taxpayer to the EAT (Note that this assignment should not be confused with the assignment of rights to the Qualified Intermediary that takes place in a forward exchange.).</li>
<li>The property acquisition financing on behalf of the EAT is either provided by the taxpayer or the taxpayer’s relationship lender, or a combination of both.&nbsp; It is customary for the EAT to issue a Note and some kind of security interest such as a mortgage or a pledge of the membership interest in the limited liability company to the lender(s).&nbsp;</li>
<li>To avoid dealing with any property tenants, the EAT will typically enter into a Master Lease with the taxpayer so that the taxpayer can act as lessor in relation to the tenants.&nbsp; This also puts the rental income into the taxpayers hand and not in the hands of the EAT.&nbsp; The EAT simply wants to receive its fee.&nbsp; The Rev. Proc. does not require the lease or loan to be arm’s length.&nbsp;</li>
<li>In addition to the QEAA, the parties typically enter into some kind of contract providing for the transfer of the property, or the membership in the LLC, to the taxpayer.&nbsp; This takes place immediately after the taxpayer’s sale of the relinquished property.&nbsp;</li>
<li>Last, depending upon the type of property being parked, there is typically a Phase One environmental report or simply an environmental indemnification agreement between the parties.&nbsp;</li>
</ul>

<p>To recap, the applicable documents generally are as follows:</p>

<ul>
<li>Qualified Exchange Accommodation Agreement</li>
<li>Assignment of Purchase Contract</li>
<li>Non-Recourse Promissory Note</li>
<li>Mortgage, Deed of Trust or Pledge Agreement of Membership Interest</li>
<li>Master Lease</li>
<li>Limited Liability Company Sale Agreement</li>
<li>Environmental Indemnity Agreement</li>
</ul>

<p>Final Step:&nbsp; Entering into a reverse exchange with an EAT does not remove the necessity of doing a conventional forward exchange of the relinquished property for the replacement property.&nbsp; Rather, it buys the taxpayer time to sell the relinquished property by arranging for the EAT to acquire the replacement property from the seller and to park it. The proceeds from the sale of the relinquished property are used to acquire the property from the EAT and the EAT uses those funds to pay back any prior loans made to the EAT for the original acquisition of the replacement property.</p>

<p>A reverse exchange parking the replacement property combined with a forward exchange looks something like the following:</p>

<p><img alt="Parking Replacement Property Reverse Exchange" src="/sites/default/files/files/Real%20Estate%20Exchanges%20-%20Parking%20Replacement%20Property%201.jpg" style="height:511px; width:714px" /></p>

<h3>2. Parking the Relinquished Property</h3>

<p>Parking the relinquished property entails similar documentation to that of a replacement property parking arrangement.&nbsp; Conceptually, this arrangement is no different than a white knight showing up on the taxpayer’s doorstep to buy her property on the eve of the replacement property acquisition.&nbsp;</p>

<ul>
<li>Per the Rev. Proc. an overarching agreement must be entered into between the taxpayer and the EAT known as the QEAA.&nbsp;</li>
<li>There will be a contract between the taxpayer and the EAT providing for the EAT’s purchase of the relinquished property.&nbsp;</li>
<li>Generally if that property has debt on it, the EAT can acquire the property subject to the debt allowing for the property to be purchased for the amount of the taxpayer’s equity.&nbsp; That equity amount can be acquired through a bank loan or a direct loan from the taxpayer to the EAT.&nbsp; Any amount lent to the EAT will be used immediately by the EAT to acquire the property and the amount of equity paid goes into the taxpayer’s forward exchange account.&nbsp;</li>
<li>There is a Note and a security instrument reflecting the amount lent to the EAT.</li>
<li>A Master Lease allows for the taxpayer to deal directly with the tenants.&nbsp;</li>
<li>Depending upon the type of property, there may be a requirement for a Phase One Environmental Audit or an environment indemnity agreement.</li>
<li>Last, there may be some type of surety document which will provide for the taxpayer to be responsible for the representations and warranties made to the ultimate buyer of the relinquished property upon sale to that party by the EAT.&nbsp;&nbsp;</li>
<li>When the relinquished property is sold by the EAT to a permanent buyer, the funds received by the EAT are used to pay back any loans originally made to the EAT as well as any debt that the EAT acquired the property subject to.&nbsp;</li>
</ul>

<p>To park the relinquished property, the applicable documents generally are as follows:</p>

<ul>
<li>Qualified Exchange Accommodation Agreement</li>
<li>Agreement for the Purchase of the Relinquished Property</li>
<li>Non-Recourse Promissory Note</li>
<li>Mortgage, Deed of Trust or Pledge Agreement of Membership Interest</li>
<li>Master Lease</li>
<li>Environmental Indemnity Agreement</li>
<li>Surety Instrument</li>
</ul>

<p><strong>Final Step</strong>:&nbsp; Entering into a reverse exchange with an EAT does not remove the necessity of doing a conventional forward exchange of the relinquished property for the replacement property.&nbsp; Rather, it buys the taxpayer time to sell the relinquished property by transferring that property to the EAT, thereby triggering a sale of that property, allowing the taxpayer to acquire the replacement property on a non-reverse basis and taking up to six months (shorter in some cases) to find a permanent buyer.</p>

<p>A reverse exchange parking the relinquished property combined with a forward exchange looks something like the following:</p>

<p><img alt="Parking Relinquished Property in Reverse Exchange" src="/sites/default/files/files/Real%20Estate%20Exchanges%20-%20Parking%20Relinquished%20Property.JPG" style="height:496px; width:717px" /></p>

<h2>Determining which Property to Park</h2>

<p>When parking the replacement property the amount needed to acquire that property is a sum certain.&nbsp; However, when parking the relinquished property, it is often sold by the taxpayer to the EAT for a best guess of value.&nbsp; Inevitably, the actual amount later received by a permanent buyer will deviate up or down.&nbsp; So, when parking the relinquished property adjustments have to be made to deal with these deviations.&nbsp; So all things being equal, usually the replacement property gets parked.&nbsp; There are some factors which, when present, may suggest parking the relinquished property to be advantageous:</p>

<ul>
<li>The value of the relinquished property is much less than the replacement property so that the loan to the EAT is easy to attain</li>
<li>The replacement property may involve special financing such as a Tax Increment Financing (TIF) or a Small Business Administration (SBA) loan which requires the taxpayer to be the borrower</li>
<li>The replacement property may have some environmental issues which might involve some remediation of the issue</li>
</ul>

<p><em>Updated 2.15.2022.</em></p>

<p>During the 180-day window it takes to complete a <a href="https://www.accruit.com/blog/case-study-forward-exchange-real-estate&qu…; target="_blank" title="forward exchange">forward 1031 exchange</a>, they may lose half of their yearly earnings by first selling their current property and then looking for their replacement, the usual order of events in a forward exchange. A reverse exchange, where the replacement property is acquired before the replacement property is sold, can not only save the exchanger money but allow them to profit even more throughout the exchange process.</p>

<p>The IRS does not allow a taxpayer/exchanger to hold title or ownership to both the replacement and relinquished property simultaneously. They will let an Accommodator, usually an affiliate company of the Qualified Intermediary (QI) hold the new property title for you until you can sell your old one. Having an Accommodator hold the title of your property is called "<a href="https://www.accruit.com/blog/are-1031-reverse-tax-deferred-exchanges-re…; target="_blank" title="parking exchange">parking a property</a>”, since title to the property is placed in the name of the Accommodator. Your Accommodator can take actual title to the property by way of a single-member LLC owned by it that is explicitly opened for your exchange. This LLC is called an <a href="https://www.accruit.com/blog/case-study-reverse-exchange-real-estate-%E…; target="_blank" title="Exchange Accommodation Titleholder ">Exchange Accommodation Titleholder</a>, more commonly referred to as an EAT, and does what it says: it holds the title - nothing more. The property is then leased from the EAT, also the QI, to the taxpayer/exchanger. The EAT allows the investor to have full access to the new replacement property, also allowing access to profits from the new property right away. &nbsp;Let's use an example to break down a reverse exchange and its benefits:</p>

<blockquote>
<p><em>A commercial real estate investor owns an apartment building with a market value of $3.2 million and yields a monthly rental income of $15,000 This investor wants to upgrade their investment and purchase an office building for $5.3 million, which generates a monthly $25,000 in rental income. The investor enters into a contract to acquire the office building.&nbsp;</em></p>

<p><em>This situation is where we encounter a problem. The investor has already identified the replacement property they would like to purchase and entered into a contract to purchase. Still, they have not sold the apartment building nor begun a forward exchange. If the investor holds ownership of those properties simultaneously, they can no longer transact a tax-deferred exchange. This investor does not want to lose the opportunity of a new office building by waiting until the apartment building is sold, nor can they afford to lose the monthly rental earnings from the apartment building by following the timeline of a forward exchange. Therein lies the problem for some investors when considering a forward exchange.</em></p>

<p><em>The investor consults with their legal and tax advisors on what to do and decides to move forward with a <a href="https://www.accruit.com/blog/infographic-10-steps-reverse-exchange&quot; target="_blank" title="1031 reverse exchange">1031 reverse exchange</a>. The commercial investor coordinates with their Qualified Intermediary and begins the process. The Qualified Intermediary opens an LLC for the exchange. This LLC will be the Exchange Accommodation Titleholder, which will hold the title for the office building while the investor sells the apartment building. The creation of the LLC costs the investor about $500, and they now have full access to the office building and can begin to receive the $25,000 in monthly rental income. All while still receiving the $15,000 from the apartment building. Once the office building has been parked, the investor has 45 days to identify which property they will be selling, and the specified property is the apartment building. After the 45 days, the investor has the remaining 135 days of the initial 180 days to sell the property and finalize the exchange. The investor finds a buyer and completes the sale of the apartment building four months later.&nbsp;</em></p>
</blockquote>

<p><br />
<u><em>This is the breakdown of their costs:</em></u></p>

<ul>
<li>Office Building Rent …………………………………………. ($25,000 X 4) $100,000</li>
<li>Apartment Building Rent…………………………………. ($15,000 X 4) $60,000</li>
<li>Creation of LLC…………………………………………………. -$500</li>
<li>Exchange Fees…………………………………………………. -$7,000</li>
</ul>

<p><br />
The investor makes a total of <strong>$152,500</strong> in rental income after subtracting the cost of the LLC and exchange fees. At the end of the 180 days, the proceeds from the sale are used to transfer the title from the EAT to the investor, and the exchange is finalized. The investor in this example would have sold the apartment building in a forward exchange and then looked for the replacement property, costing him those four months of rental income from either property.</p>

<p>A common question is, how will the EAT pay for the new property? The answer is a simple. The EAT relies on the exchanger. But this does not need to be an area for concern. Under applicable rules the exchanger can enable the purchase the new property with cash or use a lender. If an exchanger uses a lender, it must be willing to have the EAT sign the security instrument for the loan, as it will be the new property owner.&nbsp;Since the EAT will be the party in title on the property, it would have to sign the Deed of Trust/Mortgage to secure the loan for the lender. It would typically sign the Note as well. It is customary for the taxpayer to sign any personal guaranty for the loan. The loan is essentially non-recourse to the borrower with all recourse going to the taxpayer. The taxpayer must also prepare to add the EAT to the insurance of the parked property.</p>

<p>Finally, how can the exchanger feel sure that the EAT will not sell their property to someone else while selling their old property? Part of the term that the IRS coined in the "reverse exchange" Rev. Proc. 2000-39 on the overarching agreement, which must be put in place between the EAT and the taxpayer, is a purchase option. The purchase option is part of a "Qualified Exchange Accommodation Agreement," the legal document allowing an exchanger and the EAT to move into a parking arrangement. The purchase option gives the exchanger the exclusive right to buy the EAT replacement property, precisely what the exchanger will do right after selling. After the taxpayer sells the old, relinquished property, the EAT will use the proceeds to pay the taxpayer what they owe them and then give the asset's title to them. On limited occasion the taxpayer will be unable to sell the old property within the 180 day time limit, in which case the parked property is simply transferred directly to the taxpayer.</p>

<hr />
<p>&nbsp;</p>
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<p style="margin-bottom: 10px;">Most Section 1031 Like-Kind Exchange transactions involve a taxpayer who sells a relinquished property and then acquires a replacement property within the appropriate guidelines. An increasing number of exchangers are structuring their transactions as 1031 reverse exchanges, wherein the taxpayer first arranges for the acquisition of the replacement property and later sells their relinquished property. But there is a hybrid solution that often is overlooked – this is a combination <a href="https://www.accruit.com/property-owners/1031-exchange-explained&quot; title="forward-reverse exchange">forward-reverse exchange</a>.</p>

<h2 class="MsoNormal"><a style="mso-comment-reference:AA_1;
mso-comment-date:20210518T1416"><span style="mso-comment-continuation:2"><span style="mso-comment-continuation:3"><b>The Situation</b></span></span></a></h2>

<p class="MsoNormal">Karen currently owns a small strip center and has received an attractive offer to sell the property for $500,000. She also has a small office building she is trying to sell, also worth about $500,000. She was planning to sell both properties and combine the proceeds to acquire replacement property worth at least $1,000,000.<o:p></o:p></p>

<h2 class="MsoNormal"><a style="mso-comment-reference:AA_4;
mso-comment-date:20210518T1416"><span style="mso-comment-continuation:5"><span style="mso-comment-continuation:6"><b>The Problem</b></span></span></a></h2>

<p class="MsoNormal">Karen’s small strip center will close in about 45 days, but she has not yet received any offers on the office building. The fact that she has identified a suitable replacement property for which the seller has agreed to accept $1,000,000 if she can close in 60 days further complicates matters. With the office building being under contract and not yet the subject of negotiations, she is worried about how to accomplish her <a href="https://www.accruit.com/blog/primer-1031-exchanges-and-related-types-ex…; title="1031 exchange goals">1031 exchange goals</a>.<o:p></o:p></p>

<h2 class="MsoNormal"><b>The Solution: A Combination Forward-Reverse Hybrid 1031 Exchange<o:p></o:p></b></h2>

<p class="MsoNormal">Karen will structure the sale of her small strip center as part of a <a href="https://www.accruit.com/blog/tax-code-sections-1031-and-1033-whats-diff…; title="section 1031 like-kind exchange">Section 1031 Like-Kind Exchange</a>. After consultation with her attorney and Accruit as the Qualified Intermediary (“QI”), Karen understands both the forward 1031 exchange and <a href="https://www.accruit.com/blog/infographic-10-steps-reverse-exchange&quot; title="reverse 1031 exchange">reverse 1031 exchanges</a> process.<o:p></o:p></p>

<p class="MsoNormal">The sale of the strip center took place on March 1, 2021, and the exchange proceeds were sent directly to Accruit, the qualified intermediary, to be held on her behalf until the purchase of her replacement property. This is necessary because a taxpayer participating in a like-kind exchange cannot be in actual or constructive receipt of the net sale proceeds while the exchange is pending.<o:p></o:p></p>

<p class="MsoNormal">Within 45 days after the closing on the sale, Karen identified a one-half interest in her target replacement property using <a href="https://www.accruit.com/blog/what-are-rules-identification-and-receipt-… Rules in 1031 Exchanges</a>. Karen also worked closely with the qualified intermediary, Accruit, to begin the reverse exchange component of her transaction. Accruit, through its affiliate, known as an Exchange Accommodation Titleholder (“EAT”) will take title to the other one-half interest in Karen’s target replacement property.<o:p></o:p></p>

<p class="MsoNormal">Specifically, Karen will lend the additional $500,000 to a new LLC (let us call it Newco LLC), with the EAT as its sole member, which was established specifically for the purpose of facilitating the reverse 1031 exchange. The loan from Karen to Newco LLC will be documented by a note and secured with a pledge of the EAT’s membership interest in Newco LLC.<o:p></o:p></p>

<p class="MsoNormal">Karen ultimately closes on the acquisition of the target replacement property on April 30, 2021, with title vested 50% in her personal name and 50% in Newco LLC, as tenants in common. (Learn more about <a href="https://www.accruit.com/blog/fractional-ownership-real-estate">Tenants in Common</a>.) On June 1, 2021, while the replacement property is held by Karen and Newco, Karen enters a contract to sell the small office building, her second relinquished property, for $540,000, with a closing date of August 20, 2021. At closing, after all closing costs are paid, the net proceeds of $500,000 will be deposited into Karen’s exchange account with Accruit. Karen will acquire the remaining 50% tenancy in common interest from the EAT and will direct Accruit to transfer the funds from the exchange account to the closing agent for this portion of the transaction.<span style="mso-spacerun:yes">&nbsp; </span>Immediately Upon receipt of those funds the EAT will direct the closing agent to remit that sum to Karen to pay off the loan that was made to the EAT to acquire the new property. Upon payoff of the $500,000 loan owed to Karen, Karen receives full ownership of the replacement property.<span style="mso-spacerun:yes">&nbsp; </span>In this manner it is the same as if Karen had acquired the replacement property outright from seller.<o:p></o:p></p>

<h2 class="MsoNormal"><b>The Result<o:p></o:p></b></h2>

<p class="MsoNormal">Karen used the forward exchange for the sale of the strip center and the reverse exchange for the sale of the office building to ultimately acquire 100% of the new building, deferring the taxes on both sales in the process. In doing so, Karen exchanged from two properties worth approximately $1,000,000 into a single, more desirable building worth about the same.<o:p></o:p></p>

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