Reverse Section 1031 Exchange

	By David Zaslow Partner Real Estate Group dzaslow@rbz.com
Publication Date: Spring 2004
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 The traditional Section 1031 exchange provides that no gain or loss is recognized on the exchange of property if all the rules are met and the relinquished property is sold before the replacement property is acquired. A tax-deferred exchange is simply a method by which a property owner trades one property for another without having to pay any income tax on the transaction. The reverse exchange occurs when the replacement property is acquired before the relinquished property is transferred or, in many circumstances, before a buyer is even located. The following focuses on the reasons for doing a 1031 reverse exchange, as well as some of the basic rules:

1. Market conditions may be such that the value of the replacement properties are rapidly accelerating or the desirable properties will be less available. A reverse exchange allows you to acquire the property before values get out of reach or the property is removed from the market.

2. You are ready to close on the replacement property, but the buyer of your relinquished property is unable to close on time. If you cannot extend the closing of the replacement property, then the reverse exchange may be your only option for tax deferral.

3. You have several relinquished properties to dispose of in order to complete a typical deferred exchange within the statutory 180 days. Unfortunately, only some of the properties can be disposed of within that time. By using these proceeds to acquire only a fractional interest in the replacement property, you can do a reverse exchange for the remaining fractionalized interest, providing an additional 180 days to dispose of the remaining relinquished properties.

In order for your property to qualify for a reverse exchange, the following must be true:

1. Both the relinquished property and replacement property must be held either for investment or for productive use in a trade or business.

2. The real property must be like-kind. Real property must be exchanged for real property.

3. There must be an actual reciprocal transfer of properties – a deed for a deed.

Basically, there are two methods to accomplish a reverse exchange. The first method is accomplished by a special purpose entity designated by and affiliated with the accommodator holding title to the relinquished property. The second method is accomplished by a special purpose entity designated by and affiliated with the accommodator purchasing and holding title to the replacement property. With both arrangements, you must:

1. Enter into a Qualified Exchange Accommodation Agreement (QEAA) with the Exchange Accommodation Titleholder (EAT).

2. Loan the EAT the cash to acquire the replacement property or arrange for financing, in favor of the EAT, necessary for the acquisition of the replacement property.

3. Market and make arrangements to dispose of the relinquished property within 180 days of the transfer of the replacement property. During the first 45 days, you must identify which relinquished properties you intend to transfer as part of this reverse exchange.

4. Receive repayment of your loan to EAT from the sale proceeds of the relinquished property.

Other considerations:

1. You may incur additional state, county or local transfer taxes when the replacement property is conveyed from the Seller to the Special Purpose Entity.

2. Institutional lenders generally will not make loans to the Special Purpose Entity to acquire the replacement property even if the Exchanger guarantees the loan. If this is the case, then the only method available to accomplish the reverse exchange is the first method – Holding Title to the Relinquished Property.

3. In general, to completely defer all capital gain taxes:

■ You must use all of the net proceeds from your relinquished property in the purchase of your replacement property.
■ You must also obtain a mortgage on your replacement property equal to, or greater than, the mortgage on your relinquished property.
■ You can offset the amount of mortgage obtained on the replacement property by putting the equivalent amount of additional cash into the exchange.

4. In a like-kind exchange, if the property is exchanged to or from a related party, it must be held for at least two years.

5. It is also important that you do not have actual or “constructive receipt” of the funds during the exchange process. No funds from the transaction should be received by the taxpayer until all replacement property has been acquired.

6. You cannot exchange stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust or beneficial interest in trust or interest in a partnership.

If you exchange California real property for out-of-state real property, California tax law provides for the non-recognition of gain on the exchange. This allows you to defer the gain into the basis of the real property received. However, upon the sale of the replacement real property, now located outside of California, the portion of the gain attributable to the increase in value of the California real property during the period it was held by you will be considered income from California sources.

In conclusion, tax-free exchanges have existed for many years. Reverse exchanges are relatively new, more complicated and, as a practical matter, more difficult. In today’s world, taxpayers are very hesitant to sell their relinquished properties first because of the fear of being unable to find and close escrow on a replacement property within 180 days. The reverse exchange gives the taxpayer peace of mind by allowing him or her to acquire the replacement property first and avoid the possibility of having to pay substantial tax dollars.