Reverse Like-Kind Exchanges: How Do They Work?
Occasionally, investors are presented with an opportunity to acquire a replacement property prior to selling or passing title to the property they currently hold as an investment.
Can an investor acquire a property he/she desires before they sell their current property and still be able to defer the taxable gain on their property?
In September 2000 the IRS published Revenue Procedure 2000-37 providing "safe harbors" or guidelines for those wishing to perform a like-kind exchange in reverse. Although Revenue Procedures are not regulation, the reverse exchange will be permitted if the Revenue Procedure is followed to the letter.
What are the general requirements of a reverse exchange?
(1) A third-party Exchange Accommodation Titleholder (EAT) takes title or "such other indicia of ownership" to the replacement or relinquish property (called "parking"). The EAT cannot be a disqualified party (an agent or related party of the taxpayer).
(2) The taxpayer must have a bona fide intent to complete an exchange.
(3) A Qualified Exchange Accommodation Agreement must be executed between the taxpayer and the EAT.
(4) Replacement or relinquish property identifications must be made by the 45th day following the acquisition of the property by the EAT.
(5) The EAT must transfer title to the taxpayer (replacement property parked) or a
third party buyer (relinquish property parked) by the 180th day following the acquisition.
How are reverse exchanges different from forward exchanges?
In a forward exchange, the property is transferred through a Qualified Intermediary by assignment of contract rights and terminates upon completion of the property transfer. The obligations, representations and warranties of the contract remain with the transferor. The Qualified Intermediary is not required to take title to the property as direct deeding from seller to buyer is permissible under IRS regulations.
Unlike a forward exchange, a reverse exchange requires the EAT to take legal title to the property or "such other indicia of ownership". The EAT is treated as the beneficial owner of the property for federal income tax purposes and file federal tax returns as necessary.
Why are reverse exchanges more costly than forward exchanges?
Reverse exchanges are more costly than forward exchanges because the EAT, as owner of the parked property, has greater risks and liability associated with the burdens of ownership. In addition, in order to isolate the liability of the individual properties owned by the EAT, a separate single member LLC is formed for each property. The EAT is also responsible for maintaining accurate books and records for the property and reporting the activity on federal tax returns while in ownership. In addition to the costs passed to the taxpayer by the EAT, other costs incurred by the taxpayer when completing a reverse exchange may include bank fees, state and local transfer taxes, closing fees and title insurance.
Why are reverse exchanges difficult to finance?
Reverse exchanges tend to be difficult to finance as the taxpayer, who is the applicant for the financing and personal guarantor of the loan, will not be the title holder while the property is owned by the EAT. This generally eliminates most traditional government backed mortgages. In order to provide sufficient funds to the EAT to purchase the parked property, the reverse exchange process generally requires a commercial loan, equity from other properties, funding from related parties or cash availability.
Are there alternatives to reverse exchanges?
Given the added exchange costs and difficulties obtaining financing, reverse exchanges should be viewed as an alternative, but only after all other avenues have been exhausted. The taxpayers first approach should be to re-negotiate the settlement dates of both the relinquish properties and replacement properties so they occur in a forward order.
As each financial and tax situation may vary, the above is not intended to provide comprehensive financial, tax or legal advice to the reader. Please contact your financial advisor, CPA and/or attorney to determine if your individual circumstances are suitable for a "Like-Kind" exchange.
For FREE information on "Like-Kind" exchanges or discuss how "Like-Kind" exchanges relate to your real estate investments, please contact Jersey Realty Exchange Corporation, 701 West Avenue, Ocean City, New Jersey 08226, or by telephone at (609) 391-1031 or toll free (888) 871-1031, or by e-mail at Info@JerseyRealtYExchange.com. |
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