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Reverse Your Steps Prior to Reversing Your 1031 Exchange |
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Written by Julianna Clementi-Ryan
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Wednesday, 01 August 2007 |
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With an increasingly competitive and financially challenging development climate, it is important to review opportunities for tax savings — especially when there is still sufficient time to make decisions for 2007.
A typical 1031 exchange allows a taxpayer to sell their investment/trade or use property either simultaneously with acquiring their replacement property or through a deferred process. A deferred process usually allows the taxpayer to accomplish the acquisition feat within 180 calendar days from the date that the taxpayer sold the relinquished property. The transaction necessitates the engagement of a qualified intermediary, who steps into the selling and acquisition shoes of the taxpayer, when the transaction does not involve a swap between two parties (i.e. the party to whom the taxpayer sells the relinquished property is the same party as the party from whom the taxpayer acquires the replacement property). The qualified intermediary (“QI”) does not need to step into the chain of title to orchestrate this type of exchange. Its main responsibility is to ensure that the taxpayer does not have constructive or actual receipt of the net proceeds from the sale of the relinquished property, which is why this transaction is easy to transact and “unobjectionably” priced. The average fee for this type of deal is under $1,000.
There is another type of 1031 exchange and many taxpayers think that they have found the answer to their acquisition dilemma when they first hear about it. It is known as a reverse exchange. For those who have not heard about this type of exchange transaction, this article will explore when reversing is appropriate tool and how to avoid it when it is not.
A Reverse Exchange
It is often said that a reverse exchange is an exchange transaction that allows the taxpayer to acquire the intended replacement property prior to relinquishing the taxpayer’s old property. The term itself and this type of statement are misleading.
Instead, a reverse exchange is better explained by stating that it is a transaction that involves two steps - a parking process and an exchange process. Coupled together these processes provide for an outcome that appears to be reverse in nature.
Generally, acquisition of the intended replacement property, without the assistance of an exchange accommodation titleholder (“EAT”) invalidates the taxpayer’s ability to use the acquired property as the replacement property. An EAT’s purpose is to acquire either the taxpayer’s relinquished property or the taxpayer’s replacement property for the sole purpose of assisting the sequence of events from and exchange process perspective. If the EAT acquires the relinquished property, then the EAT becomes the purchaser of the taxpayer’s relinquished property, from an exchange perspective. On the other hand, if the EAT acquires the replacement property, then the EAT becomes the seller of the taxpayer’s replacement property, from the perspective of the exchange process. This acquisition of old or new is accomplished by having the EAT step into the chain of title. Stepping into the chain of title has inherent risks, which is why this type of exchange transaction is more complicated, intensively documented and often times “unattractively” priced.
Four common situations which legitimize the use of an EAT:
• There is no purchaser for the relinquished property, and the acquisition of the replacement property cannot be done on a contingency;
• The value of your replacement property is insufficient to fulfill your 1031 exchange obligation, and you do not intend to acquire additional replacement property to make up the “fair market value short-fall,” and you want to make improvements to the property to increase its value;
• The property to be acquired from the seller is vacant land, and the taxpayer intends to construct a new facility out of which it will conduct its business;
• The taxpayer intends to exchange one replacement property for two relinquished properties – A and B. B will not be sold until after A’s 1031 exchange process expires. In this case, the taxpayer and the EAT would acquire a tenant-in-common interest in the replacement property, at the time of settlement, to ensure that the A and B’s exchanges are exchanged with the replacement property.
When should I attempt to avoid the use of an EAT?
Unless you need to improve the property, then my answer is always! Weigh your options and analyze your costs before jumping on the reverse ride. What do you have to lose by trying a few tactics that are commonly overlooked?
• Offer your seller an incentive payment or larger earnest money deposit;
• Offer your seller a short-term lease agreement which contains an option to purchase when your relinquished property is sold.
What other technique can be implemented to avoid a reverse structure when the seller won’t postpone the acquisition date?
If you have a purchaser for your relinquished property and the whole reason why you are thinking about a reverse is that your purchaser is unable to obtain timely financing, you can negotiate to provide your purchaser with seller-financing, via an installment contract, in an effort to accelerate the closing date. The installment arrangement allows the purchaser more time to obtain independent third-party financing since the taxpayer acts as a temporary lending source. In return, the purchaser provides the taxpayer with a promissory note, as consideration for the relinquished property, which is to be satisfied as of a designated maturity date. The satisfaction of the promissory note can be accomplished over a period of installment payments or in one lump sum amount. Meanwhile, the taxpayer protects itself by retaining title to the property.
Whenever seller-financing is used to avoid a reverse, the transaction must be converted from one that would be tax deferred in accordance with IRC Section 453 (installment sales) to one which will be taxed deferred in accordance with IRC Section 1031. The conversion steps are three-fold: 1) the installment note must be made payable to the order of the QI – not the taxpayer, 2) the promissory note must be booked as an asset of the QI exchange account, and 3) the promissory note must be converted into cash before the replacement property’s acquisition date.
How a taxpayer converts the note into cash can be done in various ways. The most commonly used conversion technique is to arrange for the taxpayer, in accordance with Private Letter Ruling 200241016, to enter into a Note Purchase Agreement which allows for the acquisition of the booked installment note, from the QI. After the replacement property is acquired using the note, purchase proceeds (plus any additional funds needed to satisfy the purchase price) and the exchange transaction is terminated, the QI endorses the installment note to the order of the taxpayer. Any payments that the purchaser is required to make, in accordance with the terms of the installment note, are now sent to the taxpayer tax free. A cost comparison of this technique with that of a reverse should be analyzed prior to forging ahead with either. SLDT |
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