Most real estate professionals know the benefits of using a 1031 like-kind exchange: Exchanges offer a value-added service to their clients that is often underused, and real estate professionals who offer them are all but certain to represent their clients in the search for the replacement property.

Now there’s a new option: the 1031 reverse exchange. The reverse exchange is a mirror image of a forward exchange, and the same timeframe applies. In a forward exchange, the exchanger (taxpayer) sells a property, then buys a replacement within six months. In a reverse exchange, the exchanger (taxpayer) buys new property first, then sells previously owned property within six months. The key is that an exchanger has only one property in his name at any one time.

A like-kind exchange is simply a way to exchange property and defer taxes. In 1991, a prescribed method for executing delayed tax-deferred exchanges of investment properties was developed and made part of the regulations by the Internal Revenue Service (IRS). This section of the tax code (IRC 1031) clarified the rules and opened doors of opportunity for investors.

The IRS introduced regulations into Section 1031 that allowed the delayed exchange of investment property through the use of a qualified intermediary. These regulations created a clearly defined process for trading property without losing any equity to income taxation.

The true power of exchanging is the ability to meet investment objectives without losing equity to taxation.

Facilitating Your Exchange

A benchmark requirement for the 1031 exchange process is that “qualified intermediaries” must be used to facilitate all transactions associated with an exchange. Qualified intermediaries are not allowed to act as an agent to any party of an exchange. They must also be certain they have not acted as such for at least two years prior to the exchange.

For this reason, real estate professionals should not be concerned about losing their client to an intermediary. The intermediary works for both the real estate professional and his or her client and is bound by U.S. Treasury regulations. All intermediary fees are paid by the exchanger at closing. Often, interest earned by escrowed funds provides earnings for the exchanger that could exceed the entire cost of the exchange.

With few exceptions, the following are considered “disqualified parties” (disqualified from acting as an intermediary) by U.S. Treasury regulations:

1. Close family members, controlled corporations, partnerships or trusts in which the person desiring the exchange has a 10 percent or greater interest.
2. Agents of the investor such as:
a. An employee
b. Closing/Escrow officer
c. Attorney or accountant
d. Investment banker/broker
e. Real estate salesperson/broker

Reverse Exchanges

Up to now, most reverse 1031 exchanges have been viewed as a problem because of the lack of a standard procedure and the high probability of audit. In September 2000, the IRS issued new provisions creating a “safe harbor” that makes it easier to take advantage of “reverse” tax-deferred exchanges.

The new provisions created specific procedures that, if followed precisely, will not be challenged by the IRS. But, some complications remain for the real estate investor, including lender problems and excessive recording expenses. Lenders don’t want to make loans where accommodators will be relieved of responsibility when the title of property, traded in a reverse exchange, is transferred to the exchanger.

So, Why a Reverse Exchange?

If you understand emerging strategies for managing these complications, you can stand above your peers when it comes to providing a quality service for your clients. Why would exchangers want to enter into a reverse exchange in the first place?

Navigating the Waters

There are still some choppy waters to be navigated in the “safe harbor,” but it can be done with the assistance of well-qualified accommodators who practice professionally within the U.S. Treasury regulations.

Here is the process for reverse exchanges:

Two Options for Reverse Exchanges

When using a reverse 1031 exchange, you have two options —exchange first or exchange last.

Exchanging First

Exchanging first simply charts another course around some of the obstacles that remain in the “safe harbor.” You face these difficulties every day working in a buyer/seller environment where success is measured in dollars and days.

When exchanging first, the exchanger deeds the relinquished property to the intermediary/accommodator as the first step in the transaction. When this is done, the exchanger is free to shop, buy and close on whatever real estate he or she desires without the obligation to relinquish before replacing.

As with a typical 1031 exchange, your client must still identify the replacement property within 45 days and close within 180 days of the date on which the first property was relinquished to the accommodator.

Exchanging first works particularly well when the exchanger must secure a loan with a deed of trust or mortgage in order to close on the replacement property because it avoids the problem that most lenders have when lending to a title holder (the accommodator) who is different from the mortgagor.

It also works well when immediate acquisition is necessary because of management problems. In this case, the exchanger must execute a deed of trust or mortgage to obtain title to the replacement property immediately by facilitating the replacement of part of an active business when an exchanger wants full control immediately.

Exchanging Last

Exchanging last is the basic, and most often used, method of doing a reverse exchange. When this method is used, your client uses an accommodator to hold title to replacement property until the relinquished property closes. There are some good reasons to stick with this fundamental approach.

Exchanging last works well when your client finds that special property and needs to get it off the market before relinquishing the property he or she already owns. The accommodator can form a Limited Liability Company (LLC) to actually hold title. This measure protects your client’s investment as well as the accommodator from liability issues involving other properties the accommodator is currently holding.

This method is also a good one to use when your client elects to “build to suit.” Construction completed on a replacement property during the period when it is held by the accommodator will qualify as like-kind property.

Another good time to exchange last is when the replacement property will not fully defer the gain realized from the relinquished property. The property your client buys may need work to be ready for his or her investment purposes. There may be renovations that will increase the value of the property that can be included in the transfer value when the accommodator transfers the property to the exchanger.

If the exchanger is not certain which of several potential properties will be relinquished to complete the exchange, the exchange-last procedure allows the exchanger to identify three properties (and possibly more) as possibilities to be the relinquished property.

The process of exchanging properties is straightforward but precise. If every requirement is not met, the exchange may be damaged, allowing the IRS to declare that a sale and a purchase have taken place. You should focus on bringing your clients together with a qualified intermediary who will guide the process.

© 2002 FLORIDA ASSOCIATION OF REALTORS