Reverse exchanges give investors more options

Real Estate Weekly, Sept 28, 2005 by Marc Wieder

A reverse exchange can be a powerful and flexible vehicle for real estate investors and business owners seeking tax-deferral opportunities. To benefit from this technique, however, you must understand the costs and complexities involved and steer clear of the hazards.

Planning Your Route

In the more common "forward" exchange, a property owner engages a qualified intermediary who sells property (the "relinquished" property) and uses the net proceeds to purchase replacement property. In a reverse exchange, the replacement property is acquired before the relinquished property is sold.

The replacement property is "parked" with a special type of intermediary--called an Exchange Accommodation Titleholder ("EAT")--until the transaction is completed.

Regardless of the route you take --forward or reverse--the destination is the same: Under Internal Revenue Code Section 1031, so long as both the relinquished and replacement properties are used in business or held for investment, capital gains and other taxes are deferred until the replacement property is sold.

A reverse exchange allows you to take advantage of these tax benefits in situations where a forward exchange would be impracticable. Perhaps you've found the ideal replacement property, but you must move quickly to stake your claim.

If the seller isn't willing to delay the closing until you dispose of the relinquished property, a reverse exchange may be an attractive alternative. Reverse exchanges are particularly valuable when multiple properties are exchanged for a single replacement property.

Reverse exchanges provide an opportunity for investors to "warehouse" acquired properties, reserving the right to match them with other properties they may sell within the time limits for a tax-deferred exchange.

They can also be used in "build-to-suit" exchanges, allowing an exchanger to construct or improve a building on the replacement property before the exchange is complete.

Rules of the Road

In Revenue Procedure 2000-37, the IRS gave the green light to reverse exchanges, establishing a safe harbor for exchanges that meet certain requirements.

Unlike forward exchanges, in which qualified intermediaries typically don't take title to the property, in a reverse exchange the EAT must hold legal title to the replacement property, either directly or through a special purpose entity such as a single-member LLC.

The exchanger and the EAT must enter into a Qualified Exchange Accommodation Agreement within five business days after the EAT obtains ownership of the property.

The time limits for completing the exchange are similar to those for a forward exchange: The exchanger must identify suitable relinquished properties within 45 days after the EAT receives the replacement property and must complete the transaction within 180 days.

While a reverse exchange is in process, the EAT owns the replacement property for federal income tax purposes, but the exchanger can exercise control over the property and enjoy its economic benefits through a triple-net-lease or property management agreement.

The exchanger receives any rental income generated by the property but also assumes responsibility for real estate taxes, mortgage interest and maintenance costs. Because the exchanger doesn't own the property for tax purposes, however, it can't claim depreciation during the time the property is parked with the EAT.

Avoiding the Roadblocks

Reverse exchanges can be a valuable tool, but they also have some disadvantages. Financing a reverse exchange can be a challenge, for example, because most EATs demand nonrecourse loans (usually backed by the exchanger's personal guarantee).

Otherwise, they risk exposing their clients' properties to creditors' claims. Also, because reverse exchanges are more complex and an EAT assumes greater risk than a qualified intermediary, they are more expensive than forward exchanges.

Reverse exchanges are also riskier to the exchanger because a third party holds legal title to the property. For this reason, it's critical to select an EAT carefully. A qualified EAT should be financially stable, should possess the knowledge and experience needed to properly structure and document the exchange, and should have the flexibility and resources to meet the strict time requirements. To help shield your property from claims against the EAT or its other clients, it's preferable that the EAT segregate each exchanger's property into a separate LLC.

Institutional EATs offer a number of advantages over individuals. For one thing, certain individuals are disqualified from acting as your EAT, including your relatives, employees, attorney, accountant and real estate agent.

And institutional EATs are better insulated against the risks associated with death, disability, bankruptcy and other issues that may affect individual EATs.

Do the Math

Despite their higher cost and greater complexity, reverse exchanges offer real estate investors the flexibility to pursue tax-deferral opportunities that might otherwise be lost. To properly evaluate these opportunities, be sure to work with your tax advisors to weigh the expected tax-deferral benefit against the costs, fees, and risks associated with this type of transaction.