The Reverse 1031 Exchange Explained
In a typical 1031 Exchange, a property is sold and then replacement property is acquired. On occasion however, it may be advantageous to do the opposite; acquire property first and then sell. This is called a Reverse Exchange. In theory, it sounds simple however acquiring replacement property first in a 1031 Exchange presents a few difficulties.
First of all, funds will need to be available for the down payment on the acquisition property (keep in mind nothing has been sold yet). Second, the properties involved in an exchange cannot be owned at the same time. To properly structure a reverse exchange, an Exchange Accommodating Title Holder, or EAT (your Exchange Company), will go on title to either the property being acquired (replacement) or the property to be sold (relinquished).
If the EAT is to go on title to the replacement property, problems may arise if the investor is financing part of the acquisition costs. Many lenders balk at the idea of an EAT going on title to the property the investor is acquiring. The lender issues are as follows:
• The loan will be made to the EAT not to the Exchanger.
• The EAT will require the loan to be non-recourse.
• The EAT will require the Lender to waive its due on sale clause for transfer of the new property from the EAT to the Exchanger.
• The EAT will require the Lender to waive its requirement that the EAT sign any warranties or representations concerning the new property.
• The EAT will require the Lender to allow junior or subordinate financing on the new property.
If the lender decides not to loan on the property because of the constraints previously stated, the investor has two choices: find a new lender or structure the exchange with the EAT taking title to the relinquished property that is ultimately to be sold as a straw buyer. Challenges with the EAT acting as straw buyer include:
• The EAT will require cash to buy the property. The cash must come from the exchanger.
• The amount of cash advanced by the investor is the amount of estimated equity in the relinquished property.
• There may be a due on sale clause on the debt of the relinquished property.
• A property tax re-assessment may be made at the time title transfers
• The exchanger may be burdened with an additional county transfer tax
Also, keep in mind that with a Reverse Exchange the relinquished property must be sold within 180 days. The time-frame start at the close of escrow of the purchase property.
Despite the complications, the reverse exchange can be a powerful tool for the investor provided they are aware of the obstacles and have plenty of time to work through the challenges.
The subject matter in this newsletter is intended as general information only and not intended as tax or legal advice. Please always consult your tax or legal advisor for any specific tax or legal matters.