The Reverse Exchange
November 2, 2012
Two primary reasons for a reverse exchange are:
- Exchanger must purchase replacement property before the sale of relinquished property; and
- The purchase price (without making improvements) of the replacement property is not sufficient for a complete deferral of tax.
A reverse exchange is the opposite of a deferred like-kind exchange. In a reverse exchange, the Exchanger (i.e. a property owner seeking to defer a taxable gain under the non-recognition rules of I.R.C. § 1031) acquires the like-kind replacement property before disposing of the relinquished property. Prior to Revenue Procedure 2000-37, it was unclear whether reverse exchanges would be given non-recognition treatment by the IRS.
The following is a road map for structuring a transaction under the safe harbor protection of Revenue Procedure 2000-37.
- The Exchanger must assign its rights under the Purchase Agreement to a newly created entity, the Exchange Accommodation Titleholder (“EAT”). The EAT and the Exchanger then enter into a “Qualified Exchange Accommodation Agreement”. This agreement establishes the rights and duties of the EAT and the Exchanger. The most important duty of the EAT is to take title to the replacement property. The Exchanger, on the other hand, has the right to lease the replacement property from the EAT and to be designated as the project manager to complete construction of improvements on the replacement property.
- After the EAT takes title to the replacement property, the Exchanger has forty five (45) days to identify one (1) or more relinquished properties. The Exchanger must sell the relinquished property within the lesser of one hundred eighty (180) days of the EAT’s purchase of the replacement property or the due date of the Exchanger’s tax return for the year in which the relinquished property is sold.
- When the Exchanger sells the identified relinquished property, the cash proceeds of the sale go through a qualified intermediary who uses the proceeds to acquire the replacement property from the EAT. The replacement property is then transferred to the Exchanger.
If properly structured, the Exchanger should have no gain on the sale of the relinquished property and the same tax basis in the replacement property that it had in the relinquished property. When pursuing these types of transactions, the Exchanger should seek professional tax advice.
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