Top 1031 Tax Deferral Strategies

With interest rates remaining low and the economy continuing to improve since the recession, commercial property values are on the rise. As a result, many property owners are looking to take their profits and reposition their portfolios into assets that provide new opportunities. Faced with federal, state and local capital gain tax rates approaching 30% or more, these investors are frequently turning to 1031 Exchanges to defer their taxes and keep their money working for them.

PROBLEM: TIGHT DEADLINES

However, the tight 1031 exchange deadlines create problems.  From the closing of the Relinquished Property sale, an investor only has 45 days to identify the Replacement Properties they want to purchase and up to 180 days to close on any of those Replacement Properties. These deadlines are particularly challenging in the current market, where prices are high and cap rates are compressed.  Our clients tell us it is difficult to find deals that make sense. Additionally, lending guidelines remain tight, so even if the right property is found, obtaining financing might be impossible, which could completely unravel a 1031 exchange. In this seller’s market, finding a buyer for the Relinquished Property isn’t an issue—the problem is finding a suitable replacement.

SOLUTION: REVERSE EXCHANGE

As a result more investors are turning to the “Reverse Exchange”. While the typical 1031 Exchange involves the taxpayer selling their Relinquished Propertybefore closing on the purchase of their Replacement Property, it is possible to close on the Replacement Property first. By locking up the Replacement Property before closing on the sale, the investor can remove much of the time crunch and uncertainty that they would typically face in a 1031 exchange.

However, in order to defer capital gain, IRC §1031 requires an “exchange” of property, so the taxpayer may not own the Relinquished and Replacement Property at the same time. As a result, while the Replacement Property can close before the Relinquished Property, the taxpayer may not take title to it until afterthey have conveyed title to the Relinquished Property to a third party.

AUTHORITY

Provisions for Reverse Exchanges were not included in the statute or the final deferred exchange Treasury Regulations adopted in 1991 [26 CFR 1.1031(k)-1].  Instead, the concept was approved by the Internal Revenue Service in Revenue Procedure 2000-37, which was later amended by Revenue Procedure 2004-51. The approved structure involves a Qualified Exchange Accommodation Arrangement”  whereby an “Exchange Accommodation Titleholder” (“EAT”) acquires legal title to either the Replacement Property or the Relinquished Property until the Relinquished Property can be sold to a third party. The EAT is usually a limited liability company that is owned by the Qualified Intermediary company hired by the taxpayer to facilitate the tax deferred exchange. This structure solves the dilemma the investor faced: by “parking” title to one of the properties with the EAT, the taxpayer avoids owning both properties at the same time.

STRUCTURE

While Reverse Exchanges are like snowflakes in that no two transactions are identical in all their nuances, the steps in the imaginary “routine” transaction would be as follows:

1. The Exchanger finds the ideal Replacement Property they just can’t live without. The Seller insists on closing quickly, yet the Relinquished Property has not yet been sold. The parties go to contract;
2. One to two weeks prior to closing on the Replacement Property, the Exchanger or their attorney contacts a Qualified Intermediary, who sets up the EAT. The parties enter into a Qualified Exchange Accommodation Arrangement Agreement (“QEAA”), which may give the Exchanger a call right, and may give the EAT a put right with regard to the Replacement Property. The Exchanger also assigns the contract of sale for the Replacement Property to the EAT. Prior to closing, the Seller is given written notice of the 1031 exchange and the contract assignment;
3. The Exchanger secures financing for the EAT to acquire the Replacement Property, through a combination of the Exchanger’s own funds and institutional lenders. The EAT will typically insist that the loan terms be non-recourse to the EAT, but the Exchanger is permitted to guaranty the loan. Any funds provided by the Exchanger directly will be borrowed by the EAT pursuant to a promissory note;
4. At closing, the Seller deeds the property to the EAT, and the EAT executes all loan documents. The EAT may then also lease the Replacement Property to the Exchanger, so that the Exchanger has use of it during the Exchange Period and bears the burden for all maintenance, repairs, utilities, and other property related costs;
5. Similar to a forward exchange, from the closing of the purchase the Exchanger has 45 days to identify the Relinquished Property they hope to sell, and a maximum of 180 days to close on the Relinquished Property;
6. The Exchanger finds a Purchaser for the Relinquished Property and enters into contract. The Exchanger enters into an Exchange Agreement with the Qualified Intermediary, and assigns the benefits of the contract to the Qualified Intermediary. The Purchaser is given written notice of the 1031 exchange and the contract assignment;
7. At closing the Exchanger deeds the Relinquished Property to the Purchaser, and Purchaser pays the net sale proceeds to the Qualified Intermediary.
8. After the Relinquished Property closing, the Exchanger assigns the “call” provisions of the QEAA to the Qualified Intermediary, who then uses the sales proceeds to repay the EAT’s loan to the Exchanger. The EAT transfers the Replacement Property to the Exchanger, either by deed, or more commonly, by transferring 100% of the membership interests in the EAT to the Exchanger. This completes the reverse exchange.

OTHER FACTORS

Once again, this article outlines only the most basic reverse exchange transaction, and there are many considerations that may alter the structure.  For instance, in certain circumstances, it may be preferable to park the Relinquished Property, rather than the Replacement Property, particularly if the lender isn’t comfortable providing a loan to the EAT. In other cases, the investor may want to use the Exchange Funds to make improvements to the Replacement Property while it is still owned by the EAT. Depending on the jurisdiction, transfer tax issues may also have to be addressed. And if Replacement Property is less expensive than Relinquished Property, the taxpayer may want to acquire additional Replacement Properties after the Relinquished Property has been sold.

By understanding the basic concepts, you can provide your clients with additional options to accomplish their goals. As with any 1031 Exchange transaction, it is also crucial that the client’s accountant or other tax advisors be involved in the planning and that a Qualified Intermediary be consulted early in the process.

This article appeared in the December issue of The Suffolk Lawyer.  Michael S. Brady, Esq., is General Counsel for Riverside 1031 LLC, a national Qualified Intermediary, and Riverside Abstract LLC,     a full service, multi-state title agency.  Michael earned the Certified Exchange Specialist® designation from the Federation of Exchange Accommodators, and has over 20 years of experience in real estate and business transactions. Check out Riverside's blog on real estate topics at www.rsabstract.com/blog/ .