Financing Focus

1031 Timing

Reverse exchanges can go in either direction.

Under Internal Revenue Code Section 1031, real property held for productive use in a trade or business or for investment may be exchanged and capital gain taxes deferred through a delayed exchange, which requires the taxpayer to sell the relinquished property and thereafter acquire like-kind replacement property.

Taxpayers can also use a reverse exchange pursuant to Internal Revenue Service Revenue Procedure 2000-37. In a reverse exchange, an exchange accommodation titleholder acquires title to either property while the taxpayer locates a buyer to complete the exchange. The EAT is typically a single-member limited liability company affiliated with a qualified intermediary, which is often the single member of the LLC.

There are two types of reverse exchanges: “exchange first,” wherein the EAT acquires and holds title to the relinquished property, and “exchange last” wherein the EAT acquires and holds title to the replacement property.

Exchange First

Using funds loaned from the taxpayer, the EAT purchases the relinquished property from the taxpayer at a price estimated to be the anticipated actual sales price to the future bona fide purchaser. This sale from the taxpayer to the EAT creates the exchange proceeds, which are then used by the QI to complete the acquisition of the replacement property. At this juncture, the EAT is holding the relinquished property and the taxpayer has completed the acquisition of the replacement property.

The EAT holds title to the relinquished property until the taxpayer completes its sale to a bona fide purchaser within the 180-day exchange period, which begins with the EAT’s acquisition of relinquished property. Upon completion of the sale, the EAT uses the relinquished property sale proceeds to repay the reverse loan to the taxpayer.

The principal advantage of the exchange-first structure is elimination of the EAT’s participation in any third-party financing that may be required for the purchase of the replacement property. The principal disadvantage is the potential to underestimate the ultimate sales price, which would result in excess proceeds that could be taxable.

Exchange Last

Alternatively, the transaction may be structured whereby the EAT — again using funds loaned from the taxpayer — purchases the replacement property. Once the taxpayer has a contract to sell the relinquished property, the QI sells the relinquished property and uses the exchange proceeds to purchase the replacement property from the EAT. The EAT then uses the proceeds from its sale of the replacement property to repay the reverse loan.

The principal advantage of this structure is that any excess relinquished property proceeds may be used to purchase additional replacement properties in a separate forward or delayed exchange. The principal disadvantage is that if there is any financing required for the replacement property acquisition, the lender must consent to the EAT’s acquisition of title and execution of the loan documents. Likewise, the lender must agree that the loan is nonrecourse to the EAT.

Reverse Challenges

The taxpayer must be able to provide funds for the acquisition of the replacement property before it has sold the relinquished property. This means that the taxpayer must have — at a minimum — an amount equal to the anticipated cash proceeds from the sale of the relinquished property plus any additional funds required to satisfy the replacement property purchase price and closing costs.

In an exchange-last structure, if there is financing, the lender must agree that title to the replacement property may be parked with the EAT, and that the loan is nonrecourse to the EAT. Consequently, the taxpayer should obtain the lender’s approval for the transaction as early as possible to avoid closing delays. Since the loan is nonrecourse to the EAT, the lender will often require that the taxpayer personally guarantee the loan, which is permitted by IRS Rev. Proc. 2000-37.

In an exchange-last structure, if the cash provided by the taxpayer for the EAT’s purchase of the replacement property is less than the cash proceeds generated by the sale of the relinquished property and there was financing, the taxpayer may wish to have the EAT use those additional cash proceeds to pay down the loan in order to balance the equities in the exchange. This balancing of equities must occur prior to the taxpayer’s acquisition of title to the replacement property. Under these circumstances, the pay down should occur just prior to or concurrent with the EAT’s transfer of the replacement property to the taxpayer. The taxpayer should also negotiate with the lender in advance for a principal pay down without penalty.

Environmental Issues. Regardless of any indemnities that the taxpayer may provide in the exchange documents, the EAT must be assured that it will have no liability for environmental issues with respect to the parked property. Consequently, for any parked property that is not residential property, the taxpayer should anticipate that the EAT will require a current Phase 1 ASTM Standard E-1527-05 environmental report certified for its use in the transaction. Likewise, the taxpayer should allow sufficient time before the closing to ascertain the EAT’s requirements in this regard and for this report to be generated and reviewed by the EAT.

Taxes and Closing Costs. Since the property parked with the EAT is transferred twice, the taxpayer must anticipate the added expense of double transfer taxes and closing costs. Few, if any, jurisdictions have exceptions to the double transfer taxes. Additionally, it should be noted that most states now have “transfer of controlling interest” statutes, which preclude the opportunity of avoiding transfer tax by transferring the membership interest in the LLC in lieu of conveying title by deed.

Marna E. Mignone, JD, is vice president and corporate counsel for Old Republic Exchange Co., a qualified intermediary. Contact her at or OREXCO Vice President Julie Tumbaga at