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Shifting into Reverse

A 'Reverse' 1031 Exchange Requires Financial Strength, No Matter Which Route You Choose

A ‘Reverse’ 1031 Exchange Requires Financial Strength, No Matter Which Route You Choose

In a forward 1031 Exchange, the relinquished property is sold first, followed by the purchase of the replacement property. The proceeds from the sale of the relinquished property go toward the down payment or purchase price of the replacement property.

In a “reverse” 1031 Exchange, the replacement property is purchased before the sale of the relinquished property and therefore before the proceeds from its sale are available.

Reverse exchanges are governed by Rev. Proc. 2000-37. That tax authority holds that the taxpayer-exchanger may not hold title to both the relinquished property and the replacement property at the same time. Therefore a holding company, not controlled by the taxpayer-exchange, is created to hold title to one of the properties during the exchange.

SCENARIO 1

The holding company borrows money from the taxpayer-exchanger to buy the replacement property, and the holding company holds the replacement property for the taxpayer-exchanger until the relinquished roperty is sold.

Then the proceeds from the sale of the relinquished property are used to repurchase the replacement property from the holding company, and the loan from the taxpayer-exchanger to the holding company is repaid. The net effect is to transfer 100 percent of the equity from the relinquished property to the replacement property.

As in a forward exchange, the replacement property must be of equal or greater value than the relinquished property to defer all income taxes. Also, the relinquished property must be sold and the replacement property must be conveyed to the taxpayer-exchanger within 180 days after the holding company purchases the property.

Scenario 2 

The holding company borrows money from the taxpayer-exchanger to buy the relinquished property from the taxpayer-exchanger for an estimated value. The sale proceeds go into a 1031 account and become the down payment on the replacement property. The relinquished property is then marketed by the holding company. Upon sale of the relinquished property, the loan from the taxpayer-exchanger is repaid.

The net effect is to transfer 100 percent of the equity in the relinquished property into the replacement property. As in a forward exchange, the replacement property must be of equal or greater value than the relinquished property to defer all income taxes. Also, the relinquished property must be sold within 180 days after the holding company purchases the property.

In both scenarios, the taxpayer-exchanger must have the financial strength to buy the replacement property, using either his or her own money or borrowed money, before having access to the cash from the sale of the relinquished property.

Why would anyone do a “reverse” 1031 Exchange? In a word: control.

In a forward 1031 Exchange, the taxpayer-exchanger is trying to coordinate the sale and repurchase of property within the 45-day identification period and 180-day repurchase period. When real estate is a hot commodity, as it is right now, it is easy to sell and hard to buy. Using a “reverse” 1031 exchange allows the taxpayer-exchanger to first take care of the hard part (buying the replacement property), followed by the easy part (selling the relinquished property).

When clients call me about performing a reverse 1031 Exchange, my first question is, “Where is the money coming from?” The easiest answer is, “We have our own cash to buy the replacement property before we sell the relinquished property.” If the client answers, “We plan on borrowing the money to buy the replacement property,” then my next call is to the lender. Most lenders are new to reverse 1031 Exchanges, and the decision on which scenario to choose is often driven by the lender requirements.

Reverse exchanges can get complicated, but they always require a financially strong client.