Although many people in the real estate industry have heard of Internal Revenue Code section 1031, all may not be familiar with its practical application. If complied with, a taxpayer can exchange his existing real estate for other real estate and defer the payment of the capital gains tax.
Although many people in the real estate industry have heard of Internal Revenue Code section 1031, all may not be familiar with its practical application. If complied with, a taxpayer can exchange his existing real estate for other real estate and defer the payment of the capital gains tax. In the usual transaction, the taxpayer, through the use of a Qualified Intermediary, first liquidates the existing property, and with the proceeds of that transaction, and within 180 days, has the replacement property purchased. What happens if the replacement property is found and needs to be purchased prior to sale of the existing property? Can a §1031 exchange still be utilized?
The answer is yes and it is known as a reverse exchange.
Prior to the issuance of Revenue Procedure 2000-37, a reverse exchange usually occurred as follows:
The replacement property was located and the taxpayer entered into an agreement for its purchase. The agreement was then assigned to an entity that was owned by a Qualified Intermediary. The taxpayer then “lent” the entity the money to purchase the replacement property. If financing was involved in the purchase, the loan would be guaranteed by the taxpayer and the entity would sign the loan documents on a non-recourse basis. The entity would then enter into a management agreement or ground lease arrangement where the taxpayer would receive all of the rents and would be responsible for all of operating expenses and the loan payments. When a buyer for the existing property was found, an exchange agreement was entered into with the Qualified Intermediary who would sell the old property, convey the “parked property” to the taxpayer in satisfaction of the exchange, and repay the loan with the proceeds of the old property.
It was thought that this arrangement avoided the IRC requirements that the exchange occur within 180 days since it was generally believed that the 180 days ran from the date of the sale of the relinquished property. In order for the foregoing arrangement to work, it was necessary that neither the Qualified Intermediary nor the entity holding title to the replacement property be treated as an agent of the taxpayer.
Rev.Proc. 2000-37 set forth a “safe harbor” for reverse exchanges. It provides that if the title-holder and the Qualified Intermediary comply with its provisions, then neither the QI nor the title-holder would be deemed to be the agent of the taxpayer. So far so good. What the Revenue Procedure added is that to qualify under the safe harbor provisions the entire transaction, i.e. the purchase of the replacement property and the disposition of the old property must occur within 180 days from the acquisition of the replacement property.
The conclusion is that reverse exchanges are still viable. While it is always better to be able to utilize the safe harbor provisions of Rev. Proc. 2000-37, if the 180 day provision cannot be complied with, it may still be possible to bring about a reverse exchange but the documentation and the mechanics are more involved in order to bring about the desired result.