Most sophisticated real estate investors are familiar with the tax savings advantages of exchanges available under Internal Revenue Code §1031, but few are aware of how a "reverse" exchange works. A reverse exchange occurs when an investor wants to acquire replacement property before closing the disposition of the relinquished property.

 

Some Terminology: Although common terminology calls this type of transaction a "reverse exchange," the Exchangor does not personally acquire the replacement property first and then dispose of the relinquished property. Instead, the Exchangor arranges for an Exchange Accommodation Titleholder (an "EAT") to acquire title to either the relinquished property or the replacement property and hold it until the other leg of the transaction is ready to close. This allows the Exchangor to comply with the tax code’s "relinquish first, replace later" requirement, while satisfying a practical real estate market requirement to close on the replacement property now. A professional exchange accommodator assists the Exchangor with the transaction by setting up a separate entity as the EAT, and by acting as the qualified intermediary.

 

The "Exchange Last" Transaction: In the so-called "exchange last" transaction the EAT first acquires title to the replacement property on the Exchanger’s behalf using funds and/or credit supplied by the Exchangor.

 

After the close, the EAT leases the replacement property to the Exchangor on a "net" basis, meaning that the Exchangor receives all rental property income and pays all expenses. Once a buyer is found for the relinquished property, it is transferred to that buyer through a non-simultaneous exchange using the qualified intermediary.

After the relinquished property has been transferred, the transaction is closed with the replacement property and any net sale proceeds from the relinquished property being transferred to the Exchangor to complete the reverse exchange.

 

The "Exchange First" Transaction: In an "exchange first" transaction, the EAT acquires title to the relinquished property through an exchange prior to the scheduled closing of the replacement property; again because market forces require that the replacement property escrow close. Here, the EAT net leases the relinquished property to the Exchangor.

 

At the replacement property closing date, the Exchangor takes title to it through a standard exchange. When a buyer is found for the relinquished property, it is transferred to the buyer and any net sale proceeds from the relinquished property are used to retire any debt incurred by the EAT on its acquisition of the relinquished property.

 

General Requirements: Most rules that apply to standard exchanges also apply to reverse exchanges. In particular, all of these transactions must be set up as an exchange, rather than as a sale followed by a purchase and must be completed within 180 days. In an "exchange last" transaction, the Exchangor must identify the relinquished property within 45 days after closing on the replacement property.

 

As with all exchange transactions, the requirements are unforgiving. Be sure you have competent help.