Taxpayers often look for opportunities to sell a property they are no longer interested in and purchasing a new property. Many will take advantage of a §1031 tax-deferred real estate exchange.
However, according to the Internal Revenue Service Revenue Procedure 2000‑37, taxpayers can also consider a reverse exchange. Under a typical deferred exchange, the taxpayer sells his relinquished property, and later identifies and acquires the replacement property, typically done through a qualified intermediary or accommodator. In the reverse exchange, the steps are taken in somewhat of a reverse order; the replacement property is acquired prior to the sale of the relinquished property.
The reverse exchange is normally conducted through what is called a “parking” transaction. This is when an accommodation party acquires the desired replacement property, and “parks” the property until the taxpayer arranges for the transfer of the relinquished property. At that time, the “parked” property is then acquired by the taxpayer as the replacement property in the exchange. In some cases, the accommodation party can acquire the replacement property, and then exchange the replacement property for the relinquished property. The relinquished property is then “parked” with the accommodation party. Afterward, the accommodation party will dispose of the “parked,” or relinquished, property. Often these reverse exchanges or “parking” transactions have extended over a period of a year or more.
In addition to providing procedures for conducting a reverse exchange, the Internal Revenue Service has established certain time periods within which this type of exchange must be completed.
According to the IRS they will not challenge the qualification of property as either “replacement property” or “relinquished property” provided the property is held in a qualified exchange accommodation arrangement (QEAA). Under such an arrangement, a person or entity known as the exchange accommodation titleholder must receive what is called “qualified indicia of ownership” (or legal title) of the property in question. This titleholder must not be the taxpayer or a disqualified person, and must be subject to federal income tax. Generally, the qualified indicia of ownership means that the titleholder has the benefits and burdens of ownership of the real property.
Some important time periods to note in a reverse exchange are:
- The taxpayer and exchange accommodation titleholder must enter into an appropriate written exchange agreement within five (5) days after transfer of the ownership of the property to the exchange accommodation titleholder
- The taxpayer must identify the property to be relinquished no later than 45 days after the transfer of the property to the exchange accommodation titleholder (alternative and multiple properties may be identified as set forth within the rules)
- The exchange process must be completed 180 days after the acquisition of the property by the exchange accommodation titleholder
The Internal Revenue Service further explains that certain contractual arrangements between parties to the exchange will not cause the exchange to lose its qualification. These arrangements would include allowing the exchange accommodation titleholder to act as a qualified intermediary in the exchange. The taxpayer, or disqualified person, may guarantee obligations or advance funds to the exchange accommodation titleholder to provide funding for the exchange accommodation titleholder to acquire the replacement property. The property held by the exchange accommodation titleholder may be leased to the taxpayer or the taxpayer may otherwise manage the property on behalf of the exchange accommodation titleholder.
As with the rules for the deferred exchange that we have dealt with for several years, these rules and procedures relating to the reverse exchange must be followed in strict fashion. Also, we must always keep in mind that these procedures provide for a deferral of tax, and do not provide for an avoidance of tax.
As always, parties of a Section 1031 transaction should seek advice from a qualified attorney or accountant.
IRC Section 1031 allows taxpayers to defer the gain on the disposition of business or investment real estate, if that real estate is replaced with other business or investment real estate, within specific timeframes. Consult your tax or legal advisor for additional information on the requirements and limitations of such exchanges. Wilmington Trust 1031 Exchange LLC is a wholly owned subsidiary of Wilmington Trust, N.A. *Wilmington Trust 1031 Exchange LLC does not provide tax or legal advice to clients. Please consult professionals in those areas before making any decisions.