DEMYSTIFYING THE REVERSE EXCHANGE
Reverse exchanges are gaining in popularity, but they are often misunderstood and they can be confusing. Let's investigate the basics of this exchange structure.
Sometimes a situation arises in which an investor or property owner wants to purchase a property but wishes to sell a property that he or she already owns to provide the funds needed to purchase the new property. If the old property sells prior to closing on the new property, the investor can employ a standard Section 1031 exchange to defer capital gain taxes on the sale. But what if the investor needs to close on the new property before the old one can close, or perhaps before it is even on the market? In those situations, a reverse exchange can provide the investor the alternative he or she needs to still take advantage of the tax deferral on the sale of the old property.
How does it work? Let's boil it down to the essentials. In a standard exchange, there are four parties involved:
- The exchanger (you)
- The intermediary (us)
- The buyer of the relinquished (old) property
- The seller of the replacement (new) property.
A reverse exchange adds a fifth party - a single-purpose entity that is formed by the intermediary to hold title to either the relinquished property or the replacement property; nearly always it's the replacement property, though. This title-holding entity is known in exchange parlance as an Exchange Accommodation Titleholder, or EAT. Its sole purpose is to hold title to one of the properties, providing time for the relinquished property to sell.
As we go through the steps of a reverse exchange, you will see that the term itself is a bit of a misnomer. Nothing is actually done in reverse order. Having the EAT hold the new property merely postpones a standard exchange until the old property sells.
Once the EAT takes title to one of the properties, the clock starts. The rules allow 180 days to sell and close the relinquished property. When that happens, the intermediary can proceed with a standard exchange that transfers title from the EAT to the exchanger. The risk to the exchanger is that the old property does not sell within the 180 days. If that happens, the reverse exchange has failed and title to the new property will be passed to the exchanger. Bottom line—do what you need to do to get the old property sold during the 180-day period.
It might have occurred to you by now that, with the money to purchase the new property wrapped up in the old property, the EAT must be a really great guy to buy the new property for you and hold it until you can sell the old one. While it may be true that the EAT is a really great guy, he will not use his own money to purchase the new property for you. The funds to purchase the new property must be provided by the exchanger. There are essentially three means by which the exchanger can provide those funds: 1) he can provide cash from his back pocket or a handy bank account, or 2) he can work with his bank and the EAT to structure a loan for the new property, or 3) a combination of #1 and #2. The EAT will not want to assume any liability for the loan on the new property, but the exchanger may sign the loan papers and be liable for the debt. The bank may require additional collateral as well. While it can be cumbersome to structure such a loan, it is something we're experienced with and we're confident we can help your bank accept the arrangements.
There are two other important documents that are typically part of a reverse exchange. If the funds to purchase come from the exchanger, the EAT will execute a note that shows the funds that were loaned to the EAT to purchase the property. Other written assurances can also be provided to assure the exchanger that the EAT will pay back those funds when the closing that ultimately transfers the new property to the exchanger occurs. The second document is a net lease between the EAT and the exchanger. The net lease makes the exchanger responsible for payment of all expenses of the new property, just the same as if he or she owned it. The lease payments, if any, can be equal to any payments made on any interest due on the bank loan, if any. The lease is designed to be strictly a pass-through, allowing the EAT to cover any expenses that the exchanger cannot pay directly, and allowing the exchanger to operate the property as if he or she owned it.
Now let's address the question of WHY. Why would anyone go through all of this? There are many situations that might warrant consideration of a reverse exchange. For instance, we have structured reverse exchanges for land owners who purchased property at an auction and needed to close within a short time frame. In another case, an investor came across a deal that he did not want to miss, but the seller was not willing to wait for the investor's old property to sell. In yet another situation, the sale of the investor's old property fell apart at the last minute and he stood to lose the new property if he did not close on it. One last scenario involves peace of mind - investors sometimes take their time finding just the right deal. When that deal is found, they ask us to structure a reverse exchange. They might then put several properties on the market for sale, any one of which could function as their relinquished property should it sell. For some folks, it's actually an easier way to execute an exchange than the typical forward exchange because it avoids having to deal with identifying potential replacement properties within the 45-day window that Section 1031 allows.
There are other ways to structure a reverse exchange. This article is not intended to be comprehensive, but to provide an overview for a basic understanding of the reverse exchange process. Reverse exchanges are more expensive for the investor than a standard exchange, primarily due to the additional expense that the intermediary must incur to establish the single-purpose entity, the tax-reporting requirements for that entity, and so forth. Reverse exchange fees can be several times that of fees for a standard exchange.
To conclude, reverse exchanges are an exchange structure that is increasingly popular. In the right situations, reverse exchanges can be extremely advantageous. Should you have any questions about reverse exchanges, please feel free to contact us.
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