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
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.
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
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.
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
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.
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
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
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
email@example.com or OREXCO Vice President Julie Tumbaga at