Reverse exchanges are used when Exchangor has found the replacement property to satisfy the 1031 exchange requirements, but hasn’t prepared the relinquished property for sale. This type of exchange was implemented by the IRS as a viable option back in the year 2000. Revenue Procedure 2000-37 provides the framework on how to correctly structure a reverse exchange with the use of two different Safe Harbor parking arrangements.
It is important to note, that in any 1031 exchange, Exchangor must first relinquish the sale property and use the proceeds to purchase replacement property that is equal or greater in value. In a reverse exchange, if Exchangor were to purchase the replacement property themselves first, it would nullify the exchange. Therefore, two different parking arrangements were structured by the IRS to allow Exchangor to configure the 1031 exchange in order to meet all necessary guidelines.
PARKING THE REPLACEMENT PROPERTY
The most common type of reverse exchange is “parking” the replacement property. In this variation, Exchangor has SCES form an LLC to become the Exchange Accommodator Titleholder (“EAT”) for the replacement property. Exchangor loans funds to the EAT to purchase and “park” legal title to the replacement property. The EAT leases the property to the Exchangor under a NNN lease. This lease permits the Exchangor to receive the benefits and burdens of the property during the time it is held by the EAT.
If Exchangor needs to borrow funds from a third-party lender in order for the EAT to acquire the replacement property, then the non-recourse loan needs to be in the name of the EAT but guaranteed by Exchangor. Not all lenders provide this type of service or product. Working with SCES ensures you will work with reputable lenders who understand and are experienced with these specific transactions.
After the EAT has acquired the replacement property, Exchanger has 45 days to identify the Relinquished Property in the 1031 exchange.
Once the Relinquished property has been properly identified, Exchangor may now sell relinquished property like they normally would in a delayed exchange. Exchangor enters into an Exchange Agreement, outlining SCES’s role as a qualified intermediary, and Exchangor assigning its rights over to SCES, which allows SCES to receive the proceeds from the sale.
Exchangor will use the proceeds held with SCES to purchase the replacement property from the EAT. During this closing transaction, the funds will be used to repay Exchangor for the monies it loaned the EAT to initially acquire the property. If
Exchangor used a third-party lender to fund the transaction, additional proceeds from the sale will be used to pay that loan off or down. Title is then transferred by direct deed from the EAT to Exchangor.
PARKING THE RELINQUISHED PROPERTY
In this scenario, the Exchanger sells the relinquished property to the EAT, for a price set by Exchangor. The reverse exchange is happening simultaneously as a delayed exchange. Just as the Exchangor is entering into an agreement with the EAT (so it can act as the Buyer on the sale of the relinquished property), Exchanger is also entering into an Exchange Agreement with SCES, so it can receive exchange funds on Exchangor’s behalf.
Since the EAT does not have its own funds to purchase the relinquished property, it must borrow money. If there is an existing loan on the property, the EAT would take title “subject to” the existing third-party financing, and borrow the remaining monies from Exchangor through a Promissory Note. The value of the Promissory Note should be equal to the amount of equity Exchanger has in the relinquished property.
Now that the Exchangor has sold its relinquished property, Exchangor is ready to purchase the replacement property from the Seller. Because Exchangor did not receive actual funds from selling the relinquished property to the EAT, Exchangor must be financially capable of purchasing the replacement property, keeping in mind the values of both the third-party “subject to” loan and the Promissory Note as those values should be equal or greater in the purchase.
Once Exchangor has lined up a Buyer for the EAT to sell the relinquished property to, a new escrow will be opened. The proceeds from this sale will be used to pay of the existing “subject to” loan and the remaining funds will pay off the Promissory Note between the EAT and Exchangor. If the price set by Exchangor to the EAT for the relinquished property differs from the actual price paid by the Buyer to the EAT, the Exchangor and the EAT will enter into a purchase price adjustment agreement to either increase or decrease the original purchase price and Promissory Note amount as necessary to reflect the final purchase price.