1031 Exchange: Reverse 1031 Exchanges
Locating a Replacement Property BEFORE selling the Old Property was a common dilemma for exchangers before the year 2000. To remedy this problem, the IRS created Reverse 1031 Exchanges.
In simple terms, in a reverse exchange your Qualified Intermediary (QI) takes title to the New Property you wish to purchase and "parks" it until your Old Property is sold. Once your Old Property closes, the QI then transfers title to you.
While the process seems simple, the financing process adds a level of complexity. When the QI takes title to your New Property, the QI normally employs the services of a limited liability company (LLC). Consequently, the lender's loan is to the LLC, secured by your New Property, and guaranteed by you. This makes the loan un-salable until you are finally in title to the property.
There are a number of different reverse exchanges available. The most popular include:
- Safe-harbor – In this transaction, the accommodator takes control of or “parks” the replacement property prior to the sale of the old property. You (the exchanger) then have 45 days to identify the relinquished property or properties and must have the entire transaction complete within 180 days of the parking arrangement. If structured within the provisions of the revenue procedure, the IRS will treat this to be within a "safe-harbor" and will not challenge the transaction based upon its status as a reverse exchange. This is the safest type of reverse exchange, but the most difficult to accomplish due to its tight time frames.
- Non Safe-harbor - This reverse exchange typically looks identical in structure to the Safe-harbor reverse, yet falls outside of the Safe-harbor because it can not be completed within the time frames provided. Typically, you (the exchanger) are unable to sell your old property within 180 days of the parking arrangement, and therefore the time frames set forth by the safe-harbor are not met. This type of transaction is not necessarily a "red flag" for an audit by the IRS, but does require quite a bit more documentation and consultation by the intermediary to assure the transaction is done properly to avoid scrutiny by the IRS.
- Construction/Improvement - This type of reverse exchange allows you to “park” a piece of property or land that will be built upon or improved during the exchange period. This is the most powerful reverse exchange available, as it allows you to literally create the exchange property you will eventually exchange through development or construction. Once again, this is a much more complex transaction than a safe-harbor reverse exchange and requires a great deal more documentation. The other downside to this type of transaction is that it will typically fall outside of the timeframes set forth by the safe-harbor. This detriment does not scare off many exchangers as a number are more than willing to take on the slight risk in exchange for the tremendous flexibility provided by this type of exchange.
- Leasehold Improvement - This type of exchange is still questionable as it has not officially been recognized by the IRS as a valid arrangement. During this exchange, you (the exchanger) will actually build on property you already own; treating the building as the parked property. Technically, it is not the building that becomes the parked property, but rather a 50-year ground lease entered into between the accommodator and you. The ground lease is the actual medium that becomes the exchange property. Obviously, this too is a highly complex transaction and must have proper supporting documentation to support its formation. The complexity of this exchange has not deterred demand as an increasing number of exchangers are implementing this exchange process.
Although MEGA 1031 is providing this brief summary about the processes and fundamentals of Reverse Exchanges, we suggest you speak directly with one of our Exchange Consultants at 866.881.1031 to learn more about this very powerful instrument. We would be delighted to answer all your questions and show you how a 1031 Reverse Exchange can directly benefit you.