Learn About the 1031 Exchange Process-Do You Qualify For a Reverse Exchange?

If you have heard of the concept of a 1031 exchange, but don't know precisely what it is, you can turn to us for assistance. We specialize in helping our clients with all sorts of different exchanges, including tax deferred exchange transactions and reverse exchange transactions. This page will help you figure out whether or not you are eligible to engage in a reverse exchange. This sort of 1031 exchange is meant to allow buyers to purchase new properties now, while hanging onto real estate they want to sell until later when it might be worth more. If you believe a reverse exchange could be right for you, give us a call.

The Reverse Exchange is the opposite of the Delayed Exchange. Where the Delayed Exchange requires the Exchangor to relinquish property before he acquires property, the Reverse Exchange allows the Exchangor to acquire property first and relinquish property second. In other words, the Reverse Exchange allows an investor to acquire a new property today, when an excellent investment may be available, and sell other property later when a better price might be obtained.

The Reverse Exchange greatly expands the ability of the investor to take advantage of changes in the marketplace and to improve his or her investment position.

If you would like to find out about the reverse exchange process or the tax deferred exchange process, contact one of our experts today. We want to help your 1031 exchange transaction go as smoothly as possible.

Reverse Exchange

The Reverse Exchange is structured primarily with Revenue Procedure 2000-37 in mind. Although Reverse Exchanges have been structured for decades prior to the Revenue Procedure, many investors now follow the Revenue Procedure to receive the safe harbor benefits.

The Revenue Procedure provides that the IRS will not challenge the qualification of property as either "replacement" or "relinquished" if there is a qualified exchange accommodation arrangement (QEAA). The requirements of the QEAA are:

  1. The property is transferred to an exchange accommodation titleholder (EAT). Equity Advantage creates the EAT in the form of a LLC. The purpose of the transfer is so that the taxpayer is not the holder of the property.
  2. At the time of transfer to the EAT, it is the taxpayer’s intent that the property held by the EAT represents either the replacement and/or relinquished property.
  3. No later than five business days after the transfer of the property to the EAT, there must be a written Qualified Exchange Accommodation Agreement.
  4. No later than 45 days after the transfer of the replacement exchange property to the EAT, identification of the relinquished property or properties is required. The identification must be consistent with the existing delayed rules.
  5. The combined time period that the relinquished and replacement properties are held in the Qualified Exchange Accommodation Agreement is not to exceed 180 days.

Additionally, the Exchangor cannot receive property already owned as replacement for property to be relinquished.

Practical Considerations for the Reverse Exchange

Funding

First and foremost the Exchangor needs to have the financial ability to purchase the replacement property. Remember, the Exchangor will not have the benefit of sale/exchange proceeds since the relinquished property has not yet been sold. The Exchangor must draw upon other financial resources for the acquisition. If a loan from a commercial lender is needed, then the lender has to be willing to lend the money to the EAT.Equity Advantage knows of such lenders who can make this accommodation and may provide the information to you.

Parking

Parking refers to the EAT taking and holding title to the property during the exchange. (“Warehouse”, “station”, “place” would also be apt descriptions, but the IRS uses “park” as its metaphor.) This parking technique is used because Revenue Procedure 2000-37 prohibits the Exchangor from having ownership of the relinquished and replacement property simultaneously.

There are two parking approaches for completing a Reverse Exchange: park replacement property and park relinquished property. Deciding which property (either the replacement property or relinquished property) is parked is determined by considering a number of factors: the funding source to pay for the acquisition, liens on the relinquished property, and the equity in the relinquished property.

If the Exchangor wishes to improve the replacement property, then the replacement property must be parked. Any improvements are to be constructed prior to the Exchangor’s receipt of the replacement property.

No matter which property is parked, the property is available to the Exchangor. Equity Advantage creates a lease and property management agreement between the EAT and the Exchangor so that the Exchangor has complete access to the parked property.

Park Replacement Property

In the park replacement approach, Equity Advantage creates a new single member LLC in which Equity Advantage is the sole member of and the replacement property is the sole asset.

The new LLC serves as the EAT. The LLC borrows money from the Exchangor (and/or a lender) to acquire title to the replacement property. The LLC retains ownership of the replacement property until a buyer is found for the relinquished property. The sale proceeds go to Equity Advantage when the relinquished property is sold just as they would in a delayed exchange. The sale proceeds are then used to payoff loans incurred by the LLC. Finally, Equity Advantage's ownership of the replacement property is transferred to the Exchangor completing the exchange.

Park Relinquished Property

In the park relinquish approach, Equity Advantage creates a new single member, single asset LLC. Equity Advantage is the sole member of the LLC and the relinquished property will become its sole asset.

When the LLC acquires the replacement property, the LLC simultaneously swaps it with the Exchangor’s relinquished property. In effect, the LLC has transferred the replacement property to the Exchangor and the LLC has received title to the relinquished property. The relinquished property is owned by the LLC until a buyer is found. At the time of closing, title of the relinquished property will be transferred from the LLC to the buyer and the sale proceeds will go to Equity Advantage as they would in a delayed exchange. The sale proceeds are then used to payoff loans incurred by the LLC, completing the exchange.

Exchangor’s Guidelines to Accomplishing the Reverse Exchange

The Acquisition

  • Contact Equity Advantage
    • Inform Equity Advantage that it is your intention to participate in a Reverse Exchange.
    • Equity Advantage provides information to make sure an exchange is beneficial to you.
    • Establish an account with Equity Advantage: provide contact information and any additional property information you know at this time.
    • Establish funding to acquire your replacement property The funds may come from your exchange, personal funds, or a bank/lender. If a lender is used to provide the loan, be sure the lender is familiar with the Reverse 1031 Exchange process. (Equity Advantage is available to consult with your lender).
  • Negotiate terms of the purchase
    • Sign a purchase agreement.
    • The contract must have a paragraph stating the purchase is subject to a 1031 Exchange and the Seller agrees to cooperate with the exchange (1031 Exchange Cooperation Clause).
  • Contact your Closing Agent
    • Provide purchase information.
    • Inform the closer the purchase involves a 1031 Exchange and that Equity Advantage will be contacting them shortly.
  • Contact Equity Advantage
    • Equity Advantage gathers the additional information needed to structure the exchange: property information, closing date, sales price, Sellers information, Closing Agent information, etc.).
    • Equity Advantage generates exchange documents and sends them to all appropriate parties.
  • Provide complete funding
    • Exchangor arranges for all financing for the acquisition of the replacement property.
    • If the EAT is to hold title to the replacement property, the loan must be in the EAT’s name.
    • Provide partial funding to the EAT for the down payment or earnest money deposit that is required by the seller. (Funding is treated as a loan between you and the EAT)
    • A promissory note between the EAT and the Exchangor is secured by a trust deed.
  • Closing Occurs
    • Both parties (Exchangor and Buyer) sign Exchange Documents drafted by Equity Advantage.
    • Depending on Funding, the EAT takes title to either the replacement property or the relinquished property (this process in typically called parking). Equity Advantage will work with you to determine which property will be parked.

This completes the acquisition of your exchange. At this point, Equity Advantage has either your relinquished property or your replacement property parked.

Relinquishment

  • Review the Identification Packet sent to you by Equity Advantage
    • Equity Advantage creates and forwards an Identification Packet for your review after receiving the Final Settlement Statement from the closing agent.
    • The packet contains the following: the replacement property’s transfer date, the 45-day identification deadline, and the 180-day deadline to complete the exchange.
    • The Identification form is provided and must be filled out and signed by you, the Exchangor.
  • Identify the property or properties you plan to sell
    • This must be done by midnight of the 45th day of your exchange period.
    • Send the filled out and signed copy to Equity Advantage via fax, mail, or email.
    • THE IRS DOES NOT ISSUE EXTENSIONS unless you and/or the property is impacted by a Presidentially Declared Disaster.
  • Contact your Closing Agent
    • Provide sale information.
    • Inform the closer that the sale involves a 1031 Exchange and that Equity Advantage will be contacting them shortly.
  • Closing Occurs
    • Closing of the relinquished property must occur before the 180 day deadline.
    • Contact Equity Advantage so proper Exchange Documents are generated.
    • The next steps vary depending on if Equity advantage parks the relinquished or replacement property. (Please view Parking)

Equity Advantage’s Course of Action to Complete the Reverse Exchange

Parking

  • The EAT takes title to the replacement or relinquished property. (This process is often called "parking" the investment property. Equity Advantage will determine which property to take title to depending on bank funding, exchange requirements, the Equity of the relinquished property and the Exchangor’s preference.)
  • Equity Advantage creates a lease and/or property management agreement between the EAT and the Exchangor so that the Exchangor has access to the parked property.
  • The relinquished property is sold and the proceeds from the sale go to Equity Advantage.
  • Equity Advantage pays off the initial loan you made to the EAT.
  • After Equity Advantage pays off the initial loan you made to the EAT, any residual funds Equity Advantage has will be used to pay down the debt on the replacement property.
  • Depending upon which property Equity Advantage parks, Equity Advantage will convey ownership of the replacement property to you either by deed or assignment of the membership of the EAT. If Equity Advantage has already swapped properties with the Exchangor, the exchange is complete when Equity Advantage repays the initial loan.

Do you Qualify? Answer some basic questions to determine whether an exchange is right for you and your current situation.

"WASHINGTON STATE LAW, RCW 19.310.040, REQUIRES AN EXCHANGE FACILITATOR TO EITHER MAINTAIN A FIDELITY BOND IN AN AMOUNT OF NOT LESS THAN ONE MILLION DOLLARS THAT PROTECTS CLIENTS AGAINST LOSSES CAUSED BY CRIMINAL ACTS OF THE EXCHANGE FACILITATOR, OR HOLD ALL CLIENT FUNDS IN A QUALIFIED ESCROW ACCOUNT OR QUALIFIED TRUST." RCW 19.310.040(1)(b) (as amended)