Park Your Reverse Exchange
These 1031 Strategies Help Investors Speed Past Exchange Roadblocks.
Once upon a time, a “reverse Starker”
exchange was dreaded by most tax professionals and avoided at all
costs, even by the most savvy investors. Today, time and experience
have provided more comfort to people who deal with these unique
transactions. As a result, this former strategy of last resort fast is
becoming a preference for a growing number of real estate investors.
most Internal Revenue Code Section 1031 tax-deferred exchanges are done
on a delayed basis with the use of a qualified intermediary. The order
of events is straightforward: Exchangers first sell their current
property and then replace it with another.
But what happens
when market forces turn the neat timing upside down? When the usual
sequence of events is disrupted, many investors still may be able to
reach their goals through a reverse exchange.
In a pure reverse
Starker exchange (named for the taxpayer in the court case that allowed
delayed exchanges), an investor completes the exchange in reverse
order, taking title to the replacement property before transferring the
relinquished property. However, with the advent of more refined
strategies, this method seldom is used.
Most reverse exchanges
today follow the traditional order of events by using a third party
that is not related to the exchanger to “park” the replacement property
until the original property can be sold. Once the relinquished property
is sold, the exchanger takes title to the replacement by purchasing it
from the third party. Because the sequence is in order, the reverse
label no longer is accurate and the transaction might more aptly be
called a warehouse or parking exchange.
Given the increasing
acceptance of these types of transactions, commercial real estate
professionals should understand the basics of parking exchanges when
working with clients. A parking exchange could save a deal that
otherwise might be lost due to timing problems.
the number of successfully completed parking exchanges has risen over
the past five years, so has the all-around comfort level. Tax
professionals and investors are becoming increasingly familiar with
this structure and use it as a proactive investment strategy instead of
as a last resort.
How did this complex exchange technique
become more accepted? It likely is not due to any definitive guidelines
from the Internal Revenue Service, which, historically, has issued
little guidance on tax-deferred exchanges. In the preamble to its 1991
regulations, the IRS stated that the regulations did not apply to
reverse exchanges — yet the same writings failed to exclude or validate
In fact, the IRS appears to be warming
somewhat to these transactions. In a recent Private Letter Ruling, the
IRS addressed whether two easements would be considered like-kind. In
this case, the taxpayer received the replacement easement before
disposing of the relinquished easement. The ruling simply acknowledged
the reverse element of the exchange and did not voice any objection to
This is not uncommon: IRS letter rulings are case specific
and normally focus on one particular issue. Although the lack of
condemnation or question of the reverse aspect cannot be seen as a vote
of confidence, it optimistically might be interpreted as a tacit nod
from the IRS.
Recently, in a move that eventually may clarify
the situation, the IRS informally requested input on reverse exchanges,
asking for recommendations on ways to appropriately structure this type
of exchange. This action may indicate that the IRS is planning to issue
definitive guidelines governing reverse exchanges.
Using Parking Exchanges
basics of a standard tax-deferred exchange are simple. An exchanger
enters into a contract to sell a relinquished property and executes an
exchange agreement with a qualified intermediary before closing. After
the sale of the relinquished property, the exchanger has 45 days to
identify a potential replacement property and another 135 days (for a
total of 180 days from the sale) to purchase a replacement property.
such time frames might work in a perfect world, the realities of
dealing with these constraints may compel an investor to consider a
more sophisticated exchange strategy. The following situations are
examples of when a parking exchange might be a viable alternative to
losing a deal altogether.
Finding the Replacement Property First.
increasingly is common for an investor to find the perfect replacement
property before even offering the relinquished property for sale.
example, John owns a small office building and a piece of raw land near
an interstate. He decides the time is right to sell both investment
properties and buy a prime piece of land he has located. Together, his
relinquished properties are worth slightly less than the value of the
land he wants.
He places both properties on the market and
receives an acceptable offer on the land subject to re-zoning.
Simultaneously, John quickly submits an offer for the desired
replacement property. The owner agrees to John's offer but insists on a
30-day inspection period with another 30 days to close. Given the
desirability of the property, the owner refuses to negotiate on any
extensions or exchange contingencies.
Even if John can close
one of his relinquished properties before he has to buy his replacement
lot, he only will be able to do a partial exchange and cannot defer the
full amount of taxes. If he doesn't contract for the desired property,
however, he risks losing it and may have few options when the sale of
his existing land is completed.
A parking exchange allows him
to acquire the land he wants, sell the properties he owns, and defer
all taxes from the transaction. An exchange company agrees to provide
both the necessary qualified intermediary and parking entity services.
The company establishes a separate parking entity, usually a
corporation or limited liability corporation, that purchases the
replacement lot. John arranges for outside financing and guarantees the
loan. With the desired property warehoused, he can concentrate on
effectively marketing his land and office building.
This is an
example of an obvious situation in which a parking exchange makes
sense. It allows the investor to put his relinquished property on the
market, carefully evaluate all offers, and structure a more
advantageous sale. Adding a level of complexity can beat having a fire
sale to meet the time deadlines of a more standard exchange.
Building a Replacement Property.
owns and operates a growing carpet business from an overcrowded
suburban store. Because he desperately needs to expand, he has located
an attractive piece of land for a new, larger store. He conservatively
estimates that once he closes on the lot, it could take more than 12
months to apply for the required zoning, get permits, and complete the
new store. He wants to do a tax-deferred exchange, but he needs to stay
in his old store until the new one is ready.
In addition, the
price of the new lot is only half the value of his current property. He
estimates it will take at least 10 months to have improvements in place
that will equal the current relinquished value. Even if Bill
successfully can negotiate a deal to sell his existing store and lease
it back from the owner until his new store is ready, he will run afoul
of a 1031 statutory time frame. He won't be able to get the maximum tax
deferral from his exchange in 180 days. With a sizable tax liability
riding on the sale of his current property, Bill needs a creative
exchange strategy to accomplish his objectives.
situation, the lot must be acquired and construction started on the
replacement property well before the sale of his relinquished property.
Because the order of events is reversed, Bill should consider a parking
exchange to accommodate his timing challenges.
Bill engages a
firm to supply the necessary exchange services, which include
establishing a parking entity to purchase and hold the lot with a loan
provided by Bill. He enters into a construction-management agreement
with the parking entity to supervise construction on the lot until
completion. Once the improvements are in place and Bill's relinquished
property is sold, the third party sells the new property to Bill,
completing the exchange.
Although a replacement property can be
transferred to an investor before ultimate completion, enough
improvements must be in place to meet or exceed the replacement
property target exchange value.
Finding a Replacement Property in Time.
IRC deadline allows 45 days to identify a potential replacement
property once the relinquished property has been sold. Although several
rules govern the number of properties that can be identified, investors
most commonly list three as potential replacements. After the 45-day
identification period, the investor then must choose a property only
from this list and close on it before the 180 days are up.
deadline puts pressure on the exchanger to quickly identify properties
that realistically can be obtained and financed if necessary. Under
certain market conditions, finding properties that meet these criteria
within a short amount of time can be a daunting challenge.
example, Jenny has a piece of attractive land with a low basis. With a
new road recently approved in her area, she feels the time is right to
sell her property. She wants to do a tax-deferred exchange but fears
that when the right offer comes, she won't be able to find an equally
attractive replacement within 45 days. In her market area, new listings
often are put under contract and close in a number of days. Sellers are
less likely to consider contingency offers and more likely to dictate
A parking exchange can solve Jenny's problem. If she
feels that the timing is advantageous for selling the relinquished
property, a search for an adequate replacement property can begin
before listing the existing property. Once the property is found and a
successful offer negotiated, Jenny can enter into a parking exchange.
The amount of time that the parking entity holds the replacement
property is structured to allow adequate time to sell the relinquished
Avoiding Exchange Delays.
a standard exchange, the timing of sales and acquisitions often is
critical and delays or unexpected circumstances may jeopardize the
entire transaction. What happens when the relinquished property sale
falls apart just days before the replacement property is due to be
closed? The best way to avoid this situation is to successfully
negotiate the ability to extend any contracts. However, in today's
market, it often is impossible to negotiate time extensions, let alone
contingencies based on the buyer's ability to complete a tax-deferred
exchange. The investor who was going to do a standard exchange still
has the parking exchange as a potential alternative if a relinquished
closing is delayed or aborted.
For example, Ian owns a small
apartment building that is very time intensive to manage. When he is
approached with an attractive offer for the property, he agrees to the
contract that includes a standard financing contingency. In order to
use an exchange and defer significant taxes that would be due on the
sale, Ian quickly puts a triple-net leased property under contract. As
the sale of his apartment building nears, the buyer unexpectedly voids
the contract when his application for financing is turned down. Ian
wants to move forward with his desired replacement property.
successfully complete an exchange, Ian needs to modify his existing
exchange agreement to a parking exchange. Once the required parking
entity is included in the transaction, the new property can be
purchased and the apartment building can be offered for sale. Once it
sells, the parking entity can sell the replacement property to Ian, who
can enjoy fewer management hassles.
Structuring a Parking Exchange
methods are used most often for a parking exchange: either the
qualified intermediary warehouses the relinquished property or the
parking entity warehouses the replacement property. Although
warehousing the replacement property usually is preferred, both methods
can be coordinated successfully based on individual needs.
Warehousing the Relinquished Property.
method is less common because of the additional uncertainties it adds
to the transaction. An exchanger enters into an agreement with a
qualified intermediary. Under this agreement, the intermediary acquires
the replacement property and then transfers the replacement property to
the exchanger. The down payment for the replacement property's
acquisition is approximated to equal the equity of the relinquished
property and is structured as a loan from the exchanger to the
intermediary. At the same time, the exchanger transfers the
relinquished property to the intermediary. A simultaneous exchange has
been completed with an outstanding note to the exchanger. At a future
date, the intermediary sells the relinquished property and uses the
proceeds to repay this note.
This approach typically is more
difficult for several reasons. First, the terms of any debt on the
relinquished property must allow the intermediary to assume the
obligation, which may not be permitted. Second, it also may prove more
difficult for the exchanger to arrange financing on the replacement
property without being able to use the proceeds from the relinquished
property. Finally, the proceeds from the sale of the relinquished
property may not equal the initial loan that the exchanger advanced.
This variance can trigger a taxable event.
Warehousing the Replacement Property.
more common than the previous method, this structure also presents some
challenges. An exchange agreement is required between three parties:
the exchanger, a qualified intermediary, and a parking entity. The
parking entity first purchases the replacement property and holds it
until the exchanger is able to successfully sell the relinquished
property. The exchanger then buys the property from the parking entity
as the replacement, completing the exchange.
challenge is how to finance the purchase of the replacement property.
If the exchanger has the necessary cash on hand, he can loan these
funds to the parking entity under a separate bona fide loan agreement.
But if an outside loan is needed, the transaction becomes more
difficult. Many lenders don't feel comfortable with the structure and
security of this kind of transaction. Increasingly, though, lenders are
willing to grant the parking entity a nonrecourse loan secured by the
property, but usually will require a guarantee from the exchanger.
the parking entity could be held liable for any environmental problems
or other issues related to the replacement property during the holding
period. Double transfer taxes also would be incurred.
the issue of who manages the day-to-day operations of the replacement
property must be resolved. This usually is arranged in one of two ways.
If the replacement property is a parcel of raw land, the parking entity
often will net lease the property to the exchanger, allowing him, as a
tenant, to assume all costs and liabilities associated with the
property. Alternatively, if the property has one or more tenants in
place, the parking entity may enter into a management agreement with
the exchanger allowing him to operate the property.
Burdens and Benefits
most early reverse exchanges, only a qualified intermediary was used.
The additional use of a separate parking entity in the exchange helps
allay fears of a potential agency relationship. But even with the use
of a parking entity, the question of whether there truly is an
independent, arms-length transaction arises. In order for a valid
transaction to exist, some experts argue that the parking entity must
endure real burdens and reap real benefits. It is important to include
enough of these risks and rewards when crafting the exchange agreement.
Without any tangible burdens and benefits, some experts feel that the
IRS could challenge the role of the third party in the exchange,
ultimately invalidating the exchange.
Despite the fact that a
parking exchange is complex and more expensive, the acceptance of this
exchange strategy continues to grow. Due to the higher level of
sophistication and risk, fees typically are three to five times the
standard deferred exchange fee, and other charges for incorporation and
tax returns may be incurred.
However, a parking exchange can
work when the typical order of events in an exchange is reversed. With
the additional flexibility it can offer in a fast-paced real estate
market, its popularity should only continue to increase.
When considering any type of exchange, consult a real estate, tax, or legal professional.