Reverse Exchanges “Purchase Replacement Properties First”
Reverse Exchanges “Purchase
Replacement Properties First”
By Cherie M Embree
In today’s market, many real estate investors are placed in a unique position. Incredible replacement (purchase) properties exist, however, relinquished (sale) properties may take longer to sell in another marketplace. This is noticeable, particularly in Florida, as a result of numerous investors “moving” their investment properties from other states (which may not have a high demand) to Florida (many areas which are experiencing a “sellers market”). This situation creates one question we hear daily from our clients. Can we perform a reverse exchange? The answer, at Asset Preservation, Inc. is “Yes.”
Definition: A Reverse Exchange is a 1031 exchange transaction in which the replacement property is acquired prior to the closing of the relinquished property.
The Opportunity: This exchange variation allows investors to immediately purchase an ideal replacement property. It may also provide additional time to accomplish the actual exchange beyond the typical 180-day time frame.
The Challenge: Although many tax and legal advisors are comfortable with the reverse exchange format, there are no specific Regulations which address this variation. There are some court cases which serve as guidelines, but nothing as solid as IRS issued Regulations.
One way to avoid the reverse exchange is to delay the “closing” of the new replacement property in some manner. Some typical strategies to delay the closing include:
- Extend the closing period in the Purchase and Sale Agreement of the acquisition. This method is preferred; however, the seller may demand an additional nonrefundable earnest money deposit.
- Obtain an option to purchase on the replacement property. This option will later be assigned to the Qualified Intermediary prior to executing the option.
- Negotiate a lease option. This alternative often solves the seller’s problem of servicing the debt until the property is closed. The lease payment provides cash flow to the Lessor.
In instances where the closing cannot be delayed, the most predominant re- verse exchange structure of “parking the replacement property” is used. This method avoids the “pure” reverse exchange, which involved owning both properties at the same time. The “pure” reverse exchange is never advisable, and majority opinion holds that it would be invalidated if audited.
In the “parking the replacement property” method, the Exchanger (party performing the exchange) cannot delay closing on the replacement property and a Qualified Intermediary (“QI”) is retained to perform the reverse exchange. The Exchanger loans the purchase money to the QI to purchase the replacement property.
The QI purchases the replacement property with these funds and holds title in its name. At the time of acquisition the QI leases the property back to the Exchanger through the NNN lease. Later when the relinquished property can be closed, the QI performs a typical exchange. Replacement property is deeded to the Exchanger by the QI. The relinquished property is transferred to the Buyer and the loan to QI (which was used to acquire the replacement property originally) is paid back to the Exchanger from the proceeds of the relinquished property received by the QI.
Most tax and legal advisors consider the reverse exchange as outlined above as not affected by the 45/180 day deadlines which apply to the typical delayed exchange. In a delayed exchange, the time-frame begins at the close of the relinquished property. This does not occur in the above scenario until the QI has closed on the relinquished property. In other words, the Exchanger receives the best of both worlds–an excellent acquisition today, and no time limits in which to sell the investment property. In addition, if there are multiple properties on the market, the Exchanger is not certain which property will sell first. This method allows flexibility regardless of which property sells first.
The main drawback occurs when the Exchanger, upon acquisition of the replacement property, desires to obtain conventional financing. Remember, the QI will take title to the replacement property and conventional lenders are less than thrilled to fund a loan to the Exchanger when the QI is the party on title. Guarantees by the Exchanger and other mechanisms to secure the financing can be used, but arguably taint the structure of the exchange.
Qualified Intermediaries have varying degrees of experience with reverse ex- changes and many do not facilitate them at all. Their opinion is that the risk is too substantial to warrant their involvement. Those QI’s which do offer reverse services typically do so only after certain prerequisites have been satisfied. For example, most QI’s will want to be listed as co-insured on the fire and liability insurance policies along with concrete verification that the property is free of toxic waste and/ or environmental hazards.
As the brief analysis indicates, any one desiring to perform a reverse ex- change should use the services of professionals with reverse transaction experience. This will minimize the risk of having the exchange invalidated or, worse yet, jeopardizing the asset. All investors should seek independent tax and/or legal counsel regarding a proposed reverse exchange since Qualified Intermediary companies cannot give tax or legal advice.
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