<p>Download the free step-by-step guide, <a href="https://info.accruit.com/reverse-exchange-whitepaper">Parking the Relinquished Property in a Reverse Exchange</a>.</p>
<h2>The Facts</h2>
<p>We were contacted by a potential client about doing an Internal Revenue Code (IRC) §1031 tax deferred exchange. The client needed to acquire, or risk losing, the desired replacement property (new property) in Dillon, Colorado. However, the contract with his buyer for the sale of his relinquished property (old property) in Littleton, Colorado was not scheduled to close until November 28, 2014, a month after the date of closing for the new property. The purchase price for the new property was $562,000. </p>
<p>In a normal tax deferred exchange, or “forward exchange,” the taxpayer sells the relinquished property first and uses the exchange proceeds to acquire the replacement property. This situation, in which the taxpayer needs to take ownership of the new property prior to the sale of the old property, i.e. in a reverse sequence, is referred to as a “reverse exchange.”</p>
<h2>The Problem</h2>
<p>The client 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,” in which the taxpayer acquires the new property before the sale of the old property.</p>
<h2>The Options</h2>
<p>In response to this common conundrum, the IRS issued <a href="/exchange-library/rev-proc-2000-37-reverse-exchanges">Revenue Procedure (Rev. Proc.) 2000-37</a> to enable taxpayers to effectively buy before selling. There are two approved solutions:</p>
<ol>
<li>The exchange company purchases the taxpayer’s old property and holds it pending the sale of that property to a bona fide third party buyer. This is sometimes referred to as an “exchange first” reverse exchange.</li>
<li>The exchange company to <a href="https://info.accruit.com/reverse-exchange-whitepaper">acquire title to the replacement property and park it on behalf of the taxpayer</a> until the taxpayer sells the old property. This is sometimes known as an “exchange last” reverse exchange. </li>
</ol>
<p>When the exchange company services a routine forward exchange, it acts as a qualified intermediary (QI). When, as in the two options above, an exchange company services a reverse exchange in which it has to take title to a property, the Rev. Proc. refers to this as acting as an exchange accommodation titleholder (EAT). There are several factors for the taxpayer, their advisors and their exchange company to consider when determining whether the old property or the new property is better to park with the EAT. Those considerations may include:</p>
<ul>
<li>What are the relative values of the properties (e.g. the old property may have a value of $100k and the replacement property $1MM)?</li>
<li>Is the old property subject to debt?</li>
<li>Are there any transfer tax considerations in connection with parking either property (there is some authority that <a href="/exchange-library/irs-private-letter-ruling-200148042">parking transactions are exempt from transfer taxes</a>)?</li>
<li>Are there any environmental issues associated with either property?</li>
<li>Are there special financing issues surrounding the replacement property such as a HUD loan, TIF (tax incremental financing), Enterprise Zone, etc.?</li>
</ul>
<p>In an exchange-first reverse exchange, the EAT takes title to the old property and “parks,” or holds title to that property until the taxpayer is able to arrange a sale of that property to a third party buyer. For Section 1031 purposes, this acquisition by the EAT constitutes a “sale” by the taxpayer and this sale allows the taxpayer to restructure the transaction by “selling” the old property before buying the new property. </p>
<p><img alt="Parking the Relinquished Property in a Reverse 1031 Exchange" src="/sites/default/files/files/parking-relinquished-property-2.jpg" style="width:550px; height:319px; margin-left:5px; margin-right:5px; float:right" />Conceptually this is no different than the taxpayer finding a ready, willing and able buyer of the old property who is able to close on the purchase from the taxpayer just prior to the taxpayer’s acquisition of the new property. Since the structure allows a sale before the purchase, the sale and purchase become a standard exchange using a Qualified Intermediary to link the sale to the purchase. Use of the reverse exchange does not remove the need to do a standard forward exchange, rather the reverse exchange requires use of the EAT to acquire the property and use of the QI to affect an exchange of the old property for the new property.</p>
<p>In this type of reverse exchange, the EAT, having acquired the old property from the taxpayer, later becomes the property’s seller to an actual buyer identified by the taxpayer. Under the reverse exchange rules, the taxpayer has 180 days (or less, depending upon the tax return filing date for the year in which the property parking takes place) to arrange a sale to a third party. </p>
<p>At times, the taxpayer is unable to find a buyer within this time period or “parking period.” In this case the reverse exchange expires and the EAT simply transfers the old property back to the taxpayer. When this happens there is no valid exchange by the taxpayer of the old property for the new property. The taxpayer may still wish to do a conventional forward exchange upon the sale of the old property, but a new replacement property would need to be identified and acquired as part of that new forward exchange.</p>
<p>If, when the old property is being parked, it is already under contract, then the sale value is certain. More often than not, it is not under contract, and the taxpayer has to estimate the market value for the sale to the EAT, an estimate which may be higher or lower than the eventual sale price to the third party buyer. The drafters of the Rev. Proc. foresaw the difficulty in exactly pinpointing the sale price in advance of an actual contract with the third party buyer, and the Rev. Proc. allows the taxpayer and EAT to retroactively modify the values used at the time of the property parking to correspond with the actual facts: It is permissible that:</p>
<blockquote>
<p>“the taxpayer and the exchange accommodation titleholder enter into agreements or arrangements providing that any variation in the value of a relinquished property from the estimated value on the date of the exchange accommodation titleholder's receipt of the property be taken into account upon the exchange accommodation titleholder's disposition of the relinquished property through the taxpayer's advance of funds to, or receipt of funds from, the exchange accommodation titleholder."</p>
</blockquote>
<h2>The Solution</h2>
<p>Returning to our client, the old property had the estimated value of $163,000. The new property was under contract for $562,000. In this case, the old property had no debt on it, and the transaction began with a cash loan from the client to the EAT in the amount of $163,000. In the event the old property had debt on it, the EAT could acquire it for the value of the equity and take title subject to the existing debt. In this case, if the old property had had $100k of debt, the property could be sold to the EAT for $63k. Be cognizant of any “due on sale/transfer” provisions in connection with the debt.</p>
<p>This loan was documented by a note and secured by a pledge of the membership interest in the special purpose entitiy that was set up by the EAT, the taxpayer or their attorney to hold title. The sale of the old property to the EAT took place on October 23, 2014. The client directed that the funds be placed in his forward exchange account, and he used those funds towards the purchase of the new property on October 28, 2014. The client borrowed the difference of $399k from a bank lender to reach the total purchase price of $562k. </p>
<p>The old property was sold by the EAT to the third party buyer on November 28, 2014, as originally scheduled. The proceeds of the sale went to pay off the original cash loan from the client to the EAT and the LLC was dissolved.</p>
<p>Relinquished property reverse exchanges are documented as follows:</p>
<ul>
<li>Exchanger Information Form</li>
<li>A Qualified Exchange Accommodation Agreement (the reverse exchange agreement)</li>
<li>Sale contract between the taxpayer as seller and the EAT as buyer</li>
<li>Note from EAT to taxpayer in the amount lent to the EAT</li>
<li>Pledge of membership interest in the special purpose limited liability company used by EAT to take title to the property</li>
<li>Master Lease from the EAT to the client enabling the taxpayer to enter into tenant leases directly with the tenants and to provide property management to remain with the taxpayer</li>
<li>Environmental Indemnity Agreement from taxpayer to EAT</li>
<li>Property liability insurance in the name of the EAT</li>
</ul>
<h2>The Result</h2>
<p>The client used the reverse exchange safe harbor to effectively sell the relinquished property prior to the purchase of the replacement property and achieved tax deferral on the entire gain associated with the relinquished property.</p>
