Since 2000, a growing number of savvy real estate investors have been utilizing reverse 1031 exchanges to better leverage their equity as they grow their investment property portfolios. On October 2, 2000, the IRS promulgated Revenue Procedure 2000-37, and the reverse 1031 tax-deferred exchange was formally recognized.
Allowing exchangors to acquire replacement properties before selling or closing on the sale of their relinquished properties, the reverse exchange’s more complicated structure has kept it somewhat shrouded in mystery; consequently, in the past seven and a half years it has been utilized far less often than the more familiar forward, or straight, exchange. However, the current economic slowdown in real estate valuation across the country affecting the residential market has also affected the commercial market as well, making reverse exchanges a popular choice for astute investors.
Taxpayers seeking to diversify their portfolios now have the opportunity to purchase multiple properties whose lowered exchange values equal that of one fully tax-depreciated property in a more stable region. Similarly, investors looking to divest themselves of older “brown” properties can proactively lock in highly-sought-after “green” properties whose environmentally progressive structural design reduces maintenance and management costs, and creates a positive perception in the public arena to an investor in search of (or in need of) such credit.
The circumstances by which reverse exchanges will be considered by the IRS to fall within the “safe harbor” provisions that remove challenges to the qualification of replacement or relinquished properties and to the identification of the beneficial owners at each stage of the exchange are set forth in Revenue Procedure 2000-37. The requirements are based on the simple premise that one exchangor may not own the replacement and relinquished properties at the same time. Additionally, exchangors may not exchange properties with their agents, or with themselves. The IRS solves this problem by allowing the replacement property to be purchased by and “parked” with an exchange accommodation titleholder (EAT) until the relinquished property is sold. The exchangor’s qualified intermediary (QI) creates the EAT usually as a sole-member LLC, whose initial sole member is the QI. The EAT purchases the replacement property using funds “loaned” by the exchangor, for which the QI prepares and executes a promissory note. The EAT then rents back the property to the exchangor using a triple-net lease which passes all expenses related to the property’s maintenance through to the exchangor. The QI steps into the shoes of the exchangor for the sale of the relinquished property, collecting the sales proceeds and using them to “purchase” the replacement property from the EAT. Finally, ownership of the replacement property is transferred to the exchangor, either by a direct deed or by a transfer of membership interests in the LLC and the note is paid with the EAT’s transfer of the sale proceeds to the exchangor.
Because of the complexity of each phase of the exchange and the need for meticulous conformity with the IRS’s guidelines, investors and their attorneys should choose a QI with proven experience in successfully completing reverse exchanges. The improper preparation of any one of the required documents, or failure to comply with the myriad of IRS rules and regulations, will imperil the entire exchange. In addition, exchangors should be able to receive direction from their QI on issues such as the type of entity to be created or the correct tax reporting for the EAT during its replacement property ownership period. For the investor and the legal professional, understanding the basics of a reverse exchange is important, but retaining a well-qualified QI is essential.
Cynthia Kern, Esq. serves as legal counsel at 1031Vest, an affiliate of TitleVest and InsureVest. The New York based firm, with offices in New Jersey and Florida, handles all types of 1031 tax-deferred exchanges, including reverse 1031 exchanges. Please visit www.1031vest.com for further information or call 212.710.9444.