Introduction to Reverse 1031 Exchanges

You can acquire (purchase) your like-kind replacement property before disposing of (selling) your current relinquished property by structuring a Reverse 1031 Exchange transaction. The Reverse 1031 Exchange transaction is permitted under Revenue Procedure 2000-37, which was issued by the Department of the Treasury and the Internal Revenue Service on September 15, 2000.

This tax-deferral strategy is especially beneficial in markets where there is an imbalance between the supply and demand for income producing investment properties or where the relinquished property sale transaction fails, and you must acquire your like-kind replacement property first.

You might also be concerned about the possibility of not being able to locate, identify and acquire suitable like-kind replacement properties within the required deadlines of a forward (regular) 1031 Exchange transaction. Entering into a forward or regular 1031 Exchange transaction may create undue stress because the you must located and identify his like-kind replacement property with in 45 calendar days of closing on the relinquished property.

A Reverse 1031 Exchange gives you the flexibility to spend as much time as you need to locate suitable like-kind replacement property, without the pressure of the forward 1031 Exchange deadlines.

Reverse 1031 Exchanges Are Complex Tax Structures

1031 Exchange transactions, especially those structured as Reverse 1031 Exchanges, are exceptionally complicated income tax deferral strategies.

The sophisticated Investor will always have a good team of experienced professional advisors, including legal, tax, and financial advisors, along with a knowledgeable broker and professional, experienced, institutional Qualified Intermediary, also referred to in the real estate industry as the 1031 Exchange Accommodator or 1031 Exchange Facilitator, and an Exchange Accommodation Titleholder, with significant technical experience in tax-deferred like-kind Exchange transactions such as Exeter Reverse 1031 Exchange Services, LLC.

Investors should always seek competent legal, financial and tax counsel before entering into any tax-deferred like-kind Exchange transaction. Exeter Reverse 1031 Exchange Services, LLC is always available to meet, or participate in a conference call, with your professional legal, tax and financial advisors in order to assist you in planning your Reverse Exchange.

Treasury Department Issues Reverse 1031 Exchange Guidance

The Department of the Treasury issued Revenue Procedure 2000-37 on September 15, 2000, which included a number of safe-harbor provisions, or guidelines, for properly structuring Reverse 1031 Exchange transactions. These Reverse 1031 Exchanges structured pursuant to this Revenue Procedure are referred to as Safe-Harbor Reverse Exchanges. As you might expect, this Revenue Procedure has significantly increased the number of Reverse 1031 Exchange transactions being conducted by Investors since 2000.

Prior to 2000, Reverse 1031 Exchange transactions were completed with little technical and structural guidance from the Department of the Treasury or the Internal Revenue Service. While the technical guidance provided by the Treasury Department has clarified the issues surrounding Reverse 1031 Exchanges and provided a much higher comfort level than before, they also leave a lot of unanswered questions and create a more complex and costly 1031 Exchange structure.

Parking Property with the Exchange Accommodation Titleholder

In a Reverse Exchange, an Exchange Accommodation Titleholder, also referred to as an EAT, acquires and holds or “parks” legal title to either the Investor’s relinquished or replacement property, and the Qualified Intermediary (Accommodator or Facilitator) administers the tax-deferred like-kind Exchange portion of the transaction.

It is permissible for the Exchange Accommodation Titleholder and the Qualified Intermediary to be the same entity, although it is certainly not advisable.

Exeter Reverse 1031 Exchange Services, LLC acts as the Exchange Accommodation Titleholder and Exeter 1031 Exchange Services, LLC serves as the Qualified Intermediary (Accommodator or Facilitator).

Exchange Accommodation Titleholder (EAT)

The Exchange Accommodation Titleholder or EAT must meet all of the following requirements contained in Revenue Procedure 2000-37:

  • The EAT must own the Qualified Indicia of Ownership, which is usually the legal title to the property, at all times from the date of acquisition of the property until the property is transferred.
  • The EAT cannot be the Investor acting on his own behalf or a disqualified entity such as a related party.
  • The Exchange Accommodation Titleholder must be subject to Federal, and if applicable, state income taxes. When the EAT is set-up (organized) as and/or if it elects to be treated as a partnership or S corporation, more than 90% of its interests or stock must be owned by partners or shareholders who are subject to federal income tax.

Qualified Indicia of Ownership

Qualified Indicia of Ownership is defined as any of the following:

  • Legal title to the property.
  • Other indicia of ownership of the property that is treated as beneficial ownership of the property under principles of commercial law for the state in which the property is located (i.e. a contract for deed).
  • Interests in an entity that is considered to be a disregarded-entity for Federal income tax purposes, such as a single-member limited liability company; this entity must hold either legal title to the property or other Qualified Indicia of Ownership.

Qualified Exchange Accommodation Agreement (QEAA)

The Exchange Accommodation Titleholder (EAT) and the Investor must execute a formal written Qualified Exchange Accommodation Agreement (QEAA). The QEAA must contain the following terms and conditions as required pursuant to Revenue Procedure 2000-37:

  • The Exchange Accommodation Titleholder is holding or parking title to the property for the Investor’s benefit in order to facilitate a Reverse Exchange pursuant to Section 1031 of the Internal Revenue Code, Section 1.1031 of the Treasury Regulations and Revenue Procedure 2000-37.
  • The Exchange Accommodation Titleholder and the Investor agree to report the acquisition, holding or parking title to, and the ultimate disposition of the property on each of their respective income tax returns as required pursuant to Revenue Procedure 2000-37.
  • The Exchange Accommodation Titleholder will be treated as the beneficial owner of the parked property for all federal income tax purposes.

Non-Arms Length Contractual Arrangements

Revenue Procedure 2000-37 allows the Exchange Accommodation Titleholder and the Investor to enter into a number of non-arms length contractual arrangements to complete a Reverse Exchange transaction. These non-arms length contractual arrangements facilitate the administration of the Reverse Exchange and eliminate certain risks for the Exchange Accommodation Titleholder and the Investor.

The Investor is responsible for any losses and will receive any profits generated from the property during the time the property is held or parked by the Exchange Accommodation Titleholder.

The property will be leased from the Exchange Accommodation Titleholder by the Investor via a triple-net lease. Once leased to the Investor, the Investor will assume management responsibilities of the property, or may retain a third-party property management company while the property is parked by the Exchange Accommodation Titleholder.

Deadlines for Identifying the Relinquished Property and Transferring Parked Property

Deadlines for identifying the relinquished property to be disposed of and transferring or conveying title of the parked property by the Exchange Accommodation Titleholder are the same as those for a forward tax-deferred like-kind Exchange transaction.

Investors have 45 calendar days after the transfer (conveyance of title) of the parked replacement property to the Exchange Accommodation Titleholder to formally identify the property they intend to relinquish or dispose of as part of Reverse Exchange transaction.

Identification is not necessary when the relinquished property is parked by the Exchange Accommodation Titleholder because the tax-deferred like-kind Exchange has already been completed at the beginning of the transaction. This will be explained in more detail shortly.

In either case, the relinquished property must be sold and transferred (conveyed) to the buyer within 180 calendar days after the parked property was transferred (conveyed) to the Exchange Accommodation Titleholder.

These deadlines cannot be extended by the Investor for any reason.

Reverse Tax-Deferred Like-Kind Exchange Structures

Investors must decide whether to park the replacement property or relinquished property with the Exchange Accommodation Titleholder. This decision will vary from transaction to transaction and not all Qualified Intermediaries/Exchange Accommodation Titleholders will administer both structures. It will typically depend on whether the lender will allow the Exchange Accommodation Titleholder to acquire and park title to the replacement property when the lender is also using the same property as collateral for the financing.

There are other factors that may play a role in determining which property will be parked by the Exchange Accommodation Titleholder as well, including:

Operational Considerations. Does parking title to either property create any problems with the ongoing operation of the property? Will a change in legal ownership affect any vendor or tenant relationships?

Risk Management Considerations. Are there any specific risks to the Exchange Accommodation Titleholder that may prohibit the EAT from accepting and parking title? Have there been any hazardous or toxic substances used or stored on the property? Do the ongoing operations of the property put the EAT at risk?

Insurance Coverage Considerations. When property is parked with the Exchange Accommodation Titleholder it is usually held by the EAT in a single-member limited liability company and this may pose problems when attempting to obtain insurance coverage for the EAT during the Reverse Exchange transaction, especially if there will be construction during the course of completing the transaction.

Financing Considerations. Properties transferred or conveyed to the Exchange Accommodation Titleholder that have existing financing may risk triggering due on sale clauses with the current lender.

Liquidity Concerns. In order to defer 100% of the applicable depreciation recapture and capital gain income tax liabilities, Investors must meet three requirements when structuring tax-deferred like-kind Exchanges: (1) Exchange or trade equal or up in value; and (2) reinvest 100% of the Investors equity (net cash proceeds from sale of relinquished property); and (3) replace any debt with new debt on the replacement property. The Investor’s equity is trapped in the relinquished property because it is not sold until after the replacement property is acquired which may create liquidity or financing challenges for the Investor when structuring a Reverse Exchange transaction.

Structuring the Reverse Exchange transaction with the Exchange Accommodation Titleholder acquiring and parking legal title to the replacement property will usually be the most beneficial structure from an Investor’s perspective.

However, given the considerations outlined above, there are often situations when acquiring and parking title to the replacement property in the name of the Exchange Accommodation Titleholder is not a practical structure. In these cases, title to the relinquished property must therefore be transferred (conveyed) to and parked with the Exchange Accommodation Titleholder.

These two Reverse Exchange structures are frequently referred to as the Exchange Last Structure (parking title to the replacement property) and the Exchange First Structure (parking title to the relinquished property).

The best way to analyze and understand a Reverse Exchange transaction is to view it as two separate transactional parts with each separate from the other and yet both contractually integrated to form the Reverse Exchange transaction.

Parking Property and a Simultaneous Tax-Deferred Like-Kind Exchange

Contrary to popular opinion Revenue Procedure 2000-37 is not a Reverse Exchange Revenue Procedure. It really provides safe-harbor guidelines for structuring Reverse Exchange transactions by utilizing a “parking” structure or strategy. It is commonly called a Reverse Exchange because it allows the Investor to acquire his like-kind replacement property first and then dispose of his relinquished property at a later date.

The term Reverse Exchange is therefore really a misnomer because it actually consists of: (1) a parking transaction where either the replacement property or the relinquished property is acquired and held or parked by the Exchange Accommodation Titleholder; and (2) a simultaneous tax-deferred like-kind Exchange (not a true Reverse Exchange) occurs either at the beginning (Exchange First Structure) or at the end (Exchange Last Structure) of the Reverse Exchange transaction.

Exchange Last Parking Structure — Parking Title to the Replacement Property

The preferred Reverse Exchange strategy is the Exchange Last Structure where the Exchange Accommodation Titleholder acquires and parks title to the replacement property.

This structure provides the Investor with a great deal more flexibility in planning the acquisition and financing of the like-kind replacement property because the actual tax-deferred like-kind Exchange has not yet occurred. We do not care at this point if the Investor has Exchanged or traded equal or up in value, has reinvested his equity (cash) or has replaced any necessary debt on the like-kind replacement property because the only thing that has been completed so far is the acquisition and parking of the like-kind replacement property by the Exchange Accommodation Titleholder.

These tax-deferred like-kind Exchange requirements are easily addressed at the back end of the transaction when the simultaneous tax-deferred like-kind Exchange occurs.

Acquiring and “Parking” the Like-Kind Replacement Property

Investors enter into a legal agreement called the Qualified Exchange Accommodation Agreement (“QEAA”) with an Exchange Accommodation Titleholder (“EAT”). Exeter Reverse 1031 Exchange Services, LLC serves in the capacity of the Exchange Accommodation Titleholder.

The Exchange Accommodation Titleholder establishes a new single-member limited liability company (“LLC”) or other type of single-member special purpose entity (“SPE”) for each Reverse Exchange transaction for the sole purpose of holding or “parking” title to the like-kind replacement property.

It is important for the Investor to select and get the Exchange Accommodation Titleholder involved before the transaction closes. Once the Qualified Exchange Accommodation Agreement has been signed the Investor will assign the Purchase and Sale Agreement and any related escrow instructions or other transactional documents (if any) for the like-kind replacement property to the Special Purpose Entity set-up by the Exchange Accommodation Titleholder in preparation for closing the transaction.

The Investor will either loan and/or arrange for third-party financing for the acquisition of the like-kind replacement property to the Special Purpose Entity set-up by the Exchange Accommodation Titleholder. At the close of the like-kind replacement property transaction, the Exchange Accommodation Titleholder will receive and “park” title to the like-kind replacement property.

Interim Activity While Property is Parked with EAT

The “parked” like-kind replacement property is typically leased by the Exchange Accommodation Titleholder to the Investor using a triple net lease while the replacement property is held or “parked” by the EAT.

The ability to lease the “parked” like-kind replacement property to the Investor during this time gives the Investor the ability to operate the property, including the ability to lease the property, collect the rents and income, and pay the expenses. The Investor is not permitted to depreciate the property while it is “parked” by the Exchange Accommodation Titleholder since they do not technically own it yet (remember that the Investor still owns and is depreciating the relinquished property).

Any lease payments made by the Investor to the EAT are offset by any debt payments owed and made by the EAT to the lender or financing company. The lease payments may cover any debt service owed on outside financing. This structure is designed to be tax neutral for the Exchange Accommodation Titleholder so that any and all taxable elements will be borne by the Investor.

The Investor must identify his relinquished property within 45 calendar days after the close of the replacement property transaction, and legal title to the replacement property has been transferred or “parked” with the Exchange Accommodation Titleholder.

The Investor will then assign the Purchase and Sale Agreement and any related escrow instructions or other transactional documents (if any) for the disposition of the relinquished property to Exeter 1031 Exchange Services, LLC, as the Qualified Intermediary for the Investor. The Exchange funds at the close of the relinquished property transaction will be sent to the Qualified Intermediary.

Acquisition of the Replacement Property from the EAT

The Qualified Intermediary will use these tax-deferred like-kind Exchange funds to acquire the “parked” like-kind replacement property from the Exchange Accommodation Titleholder.

The Qualified Intermediary acquires the “parked” like-kind replacement property by executing a Purchase and Sale Agreement. The Investor will receive their “parked” replacement property or 100% of the membership interests or ownership in the Special Purpose Entity that holds legal title to the “parked” replacement property from the Exchange Accommodation Titleholder by completing a simultaneous Exchange. The Exchange Accommodation Titleholder uses the net proceeds received from the sale of the relinquished property to pay down the loan to the third-party lender and/or the Investor.

The Investor should obtain their lender’s approval prior to entering into an “Exchange Last” Reverse Exchange transaction if he needs to secure institutional financing. The SPE/LLC will be the borrower on the loan since the SPE/LLC holds title to the property. The Exchange Accommodation Titleholder will typically sign the loan documents on a non-recourse basis and the Investor can guarantee the loan documents on a recourse basis.

Make sure that your lender understands that you are contemplating a Reverse Exchange transaction and not a regular forward tax-deferred like-kind Exchange. I have seen lenders say yes all too often only to say no just a few days before the closing when they find out that the Exchange Accommodation Titleholder will be holding title to the like-kind replacement property. I recommend that the Investor, lender and Exeter 1031 Exchange Services, LLC schedule a conference call as early as possible to discuss the specific issues with a Reverse Exchange.

Reverse Improvement Tax-Deferred Like-Kind Exchange

The “Exchange Last” structure can be utilized in a Reverse improvement tax-deferred like-kind Exchange structure as well (sometimes referred to as build-to-suit or construction tax-deferred like-kind Exchange). In this type of tax-deferred like-kind Exchange, the Investor can build a new structure, improve an existing structure or retrofit the property before selling their relinquished property.

When to Use the Exchange Last Parking Structure

Investors typically select the “Exchange Last” structure for a Reverse Exchange transaction when they are purchasing the like-kind replacement property for all cash or the seller is providing short-term financing (seller-carry back financing).

The following table will help you walk through the steps of an “Exchange Last” structure.

Exchange Last Parking Structure — Parking Title to the Replacement Property

 

Investor enters into a Qualified Exchange Accommodation Agreement with the Exchange Accommodation Titleholder.
Exchange Accommodation Titleholder forms limited liability company (LLC) or other special purpose entity to acquire title to property.
Investor assigns its rights under Purchase Contract for like-kind replacement property to Exchange Accommodation Titleholder and provides written notification to all parties involved in the transaction.
Investor advances money from itself and/or obtains third-party financing for the limited liability company (LLC) to fund the purchase of the like-kind replacement property. The loan is non-recourse to the LLC and its member but can be guaranteed by the Investor on a recourse basis.
Exchange Accommodation Titleholder acquires title to like-kind replacement property directly from seller and gives Investor and/or other lender a note(s) that is secured by a deed of trust or mortgage on the replacement property.
Under the QEAA, Investor leases replacement property from Exchange Accommodation Titleholder under a triple-net lease. Investor’s monthly rent (if any) may cover any debt service owed on outside financing.
Investor identifies relinquished property within 45 calendar days after the closing and parking of the like-kind replacement property.
Investor executes Sales Contract with buyer to sell relinquished property.
Investor executes Tax-Deferred Exchange Agreement with Qualified Intermediary
Investor assigns its rights under the Sales Contract to Qualified Intermediary and gives written notice to buyer.
Relinquished property closes with Investor direct deeding property to purchaser and closer disbursing all Exchange proceeds from relinquished property to Qualified Intermediary.
Investor and Exchange Accommodation Titleholder execute Purchase and Sales Contract for like-kind replacement property.
Investor assigns rights under Purchase and Sales Contract for like-kind replacement property to Qualified Intermediary.
At closing, Qualified Intermediary pays off Investor and/or lender in satisfaction of note(s) given by Exchange Accommodation Titleholder to Investor and/or lender. Closing must be simultaneous with the relinquished property closing.
Qualified Intermediary instructs Exchange Accommodation Titleholder to either transfer title to like-kind replacement property directly to Investor or to transfer 100% of the membership interest in Exchange Accommodation Titleholder to Investor, completing a simultaneous Exchange.
Exchange Accommodation Titleholder will usually not hold title of the like-kind replacement property for more than 180 calendar days.

Issues with Exchange Last Parking Structure

Cash Boot Potential: If the amount of the down payment advanced by the Investor to the Exchange Accommodator Titleholder (initial equity) used to acquire the like-kind replacement property is less than the equity generated from the sale of the relinquished property the Investor may have accidentally created cash boot and will recognize depreciation recapture and/or capital gain income tax liabilities to the extent of the cash boot. (Note: To qualify for 100% tax-deferral in a tax-deferred like-kind Exchange, the equity in the like-kind replacement property must be equal to or greater than the equity in the relinquished property.)

The Exchange Last parking structure is the only one of the two that would allow the Exchange Accommodation Titleholder to contribute additional cash if the equity from the relinquished property is more than the down payment on the like-kind replacement property to avoid a tax liability.

Financing: If seller carry back financing is not available, then you must pay cash for the like-kind replacement property or arrange institutional or other third-party financing. `Obtaining third-party financing, especially institutional financing, is often difficult because of the parking structures. If third-party financing is available, the Exchange Accommodation Titleholder will only execute a non-recourse loan and deed of trust or mortgage that will typically be guaranteed by you. When you take title to the like-kind replacement property, you must assume any outstanding loan balances on a subject to basis.

Exchange First Parking Structure — Parking Title to Relinquished Property

In an Exchange First parking structure the relinquished property is acquired, held or parked by the Exchange Accommodation Titleholder and a simultaneous or concurrent tax-deferred like-kind Exchange transaction is completed by selling (transferring or conveying) the relinquished property to the Exchange Accommodation Titleholder and simultaneously acquiring and closing on the like-kind replacement property.

The relinquished property may not be transferred to a disqualified entity such as a related party of the Investor or to an agent of the Investor. When you find a buyer for the parked relinquished property, the Exchange Accommodation Titleholder deed title of the relinquished property directly to the buyer at the close of the transaction and forwards any net sales proceeds to the Investor in repayment of the funds advanced to complete the Reverse Exchange.

In the “Exchange First” parking structure, the Investor will assign a Purchase and Sale Agreement for the relinquished property to the Qualified Intermediary. The Investor will enter into a Qualified Exchange Accommodation Agreement (“QEAA”) with the Exchange Accommodation Titleholder. The Exchange Accommodation Titleholder sets up a single-member limited liability company (LLC) or other special purpose entity to acquire, hold or park title to the relinquished property.

The Investor will sell the relinquished property to the Exchange Accommodation Titleholder in order to complete the simultaneous tax-deferred like-kind Exchange transaction. The Investor and/or his lender will loan funds to the Exchange Accommodation Titleholder, and the Exchange Accommodation Titleholder will execute a note and deed of trust or mortgage in favor of the lender.

The Exchange Accommodation Titleholder uses this financing to acquire, hold or park title to the relinquished property from the Qualified Intermediary. The Qualified Intermediary uses these advanced funds received from the Exchange Accommodation Titleholder to purchase the like-kind replacement property on your behalf. The like-kind replacement property is conveyed directly to the Investor simultaneously with the conveyance of the relinquished property to the Exchange Accommodation Titleholder and the simultaneous tax-deferred like-kind Exchange is completed.

Once a buyer for the relinquished property is found, the proceeds from the sale of the relinquished property are used to satisfy any financing obtained to complete this Reverse Exchange.

When to Use Exchange First Parking

An “Exchange First” parking structure may be a more viable option than an “Exchange Last” when you need to obtain conventional institutional financing on the like-kind replacement property.

Lenders may have difficulty lending on property that is held by a third-party such as an Exchange Accommodation Titleholder on behalf of the Investor.

Exchange First Parking Structure — Parking Title to the Relinquished Property

Investor selects relinquished property from his portfolio.
Investor executes a Qualified Exchange Accommodation Agreement (QEAA) with Exchange Accommodation Titleholder.
Exchange Accommodation Titleholder forms an limited liability company (LLC) or other special purpose entity to park title to relinquished property.
Exchange Accommodation Titleholder and Investor execute Purchase and Sale Agreement for the sale of the relinquished property to the Exchange Accommodation Titleholder.
Investor advances funds to or arranges for third-party financing for the Exchange Accommodation Titleholder to “purchase” the Investor’ relinquished property.
Investor executes Tax Deferred Like-Kind Exchange Agreement with Qualified Intermediary (Exeter 1031 Exchange Services, LLC).
Investor assigns Purchase and Sale Agreement for relinquished property to Qualified Intermediary and notifies purchaser (Exchange Accommodation Titleholder).
Exchange Accommodation Titleholder disburses funds advanced or loaned to it directly to the Qualified Intermediary; and the Qualified Intermediary instructs Investor to convey relinquished property to Exchange Accommodation Titleholder.
Investor enters into a Purchase and Sale Agreement for their like-kind replacement property.
Investor assigns Purchase and Sale Agreement for like-kind replacement property to Qualified Intermediary and the Seller of the like-kind replacement property.
Qualified Intermediary disburses loan funds provided by Exchange Accommodation Titleholder to seller of the like-kind replacement property and directs seller to deed the like-kind replacement property directly to the Investor. Exchange is now completed.
Exchange Accommodation Titleholder leases the relinquished property to the Investor under a triple-net lease.
Investor enters into Purchase and Sales Agreement with buyer for Investor’s relinquished property that is now being held by the Exchange Accommodation Titleholder.
Investor assigns Purchase and Sales Agreement to Exchange Accommodation Titleholder and notifies buyer of the assignment.
Exchange Accommodation Titleholder closes on relinquished property sale and uses sales proceeds from relinquished property to satisfy a note(s) given to Investor and/or other lender.
Exchange Accommodation Titleholder cannot hold the relinquished property for more than 180 calendar days.

 

Issues with “Exchange First” Parking Structures

Cash Boot Potential: If the equity in the relinquished property is greater than the cash invested in the like-kind replacement property, then the Investor may incur depreciation recapture and capital gain income tax liabilities. Since the Investor has already purchased his like-kind replacement property and completed a simultaneous tax-deferred like-kind Exchange up front, he will not have the opportunity to balance his tax-deferred like-kind Exchange by investing additional equity at the back end when his relinquished property ultimately sells. For this reason, having the Exchange Accommodation Titleholder hold the like-kind replacement property under an Exchange Last Parking Structure is usually the preferred method as opposed to the Exchange First Parking Structure.

Relinquished Property Loan: By transferring the relinquished property to the Exchange Accommodation Titleholder, the Investor runs the risk of triggering the due-on-sale clause in his relinquished property note. This is one of the reasons that many Exchange Accommodation Titleholders will not acquire, hold and park title to the Investor’s relinquished property.

Pre-Exchange Due Diligence

Before setting up a Reverse Exchange, the Exchange Accommodation Titleholder will require the Investor to provide the following documents and information:

  • Financial statements and/or Federal income tax returns for the last two or three income tax years;
  • Grant deed for the relinquished properties showing legal title as currently held by the Investor;
  • Binder providing proof of property, casualty and liability insurance coverage and naming the limited liability company (LLC) as the named insured and the Exchange Accommodation Titleholder (EAT) and the Investor as additional named insured;
  • Phase I Environmental Assessment report issued within the last 6 months. The report must indicate that the real property is free of contamination and be certified to the Exchange Accommodation Titleholder. This is typically required on all types of properties, although certain Exchange Accommodation Titleholders may waive this requirement for certain types of property zoned residential; and
  • Title insurance binder naming the Exchange Accommodation Titleholder as the named insured (real property). The Investor should inquire as to how the title insurance policy will be assigned to the Investor upon completion of the Reverse Exchange transaction.

Issues with Reverse Tax-Deferred Like-Kind Exchanges

The costs surrounding Reverse Exchanges are considerably more than those for a forward tax-deferred like-kind Exchange transaction.

Fees for Reverse Exchange transactions are higher than fees for forward, delayed tax-deferred like-kind Exchange transactions primarily due to the significantly increased risk that is assumed by the Exchange Accommodation Titleholder (EAT) when acquiring, holding and “parking” legal title to the Investor’s relinquished or replacement property.

The Investor will also incur additional title insurance, environmental, loan, legal, property, casualty and liability insurance, and escrow/closing costs depending on the structure of the Reverse Exchange.

There is also the potential for double taxation of state, county or local taxing authorities such as transfer taxes, property taxes due to incorrect or premature reassessment when either the relinquished or the replacement property is conveyed to the Exchange Accommodation Titleholder and then transferred to the buyer (“Exchange First”) or to the Investor (“Exchange Last”).

However, in a recent Private Letter Ruling (PLR 200148042), the Internal Revenue Service approved an express declaration of agency for all purposes except federal income tax purposes that could be included in the Exchange Accommodation Titleholder’s Qualified Exchange Accommodation Agreement with out jeopardizing the qualification of the transaction as a Reverse Exchange.

Conveying title to property from an agent to a principal is not a taxable event in most taxing jurisdictions. While the Private Letter Ruling only pertains to the ruling obtained by the specific taxpayer in this case, this nonetheless provides some insight into the Internal Revenue Service’s views on the matter.

Investors can not depreciate the like-kind replacement property acquired, held and parked by the Exchange Accommodation Titleholder until the Investor has acquire title to the like-kind replacement property or has transferred the relinquished property to the Exchange Accommodation Titleholder.

The Exchange Accommodation Titleholder does not depreciate the property acquired, held and parked. The property is held on its books as inventory held for ultimate disposition.

Alternative Strategies to Reverse 1031 Exchanges

After reviewing the costs involved in a Reverse Exchange, Investors may want to consider approaching the seller of the like-kind replacement property to see if the transaction can be delayed until a buyer can be found for the relinquished property. This way the transaction can be restructured into a forward 1031 Exchange.

The Investor may want to consider securing his like-kind replacement property by including contingency language in the purchase and sale agreement so that the acquisition closing can be delayed until the relinquished property is in a position to close concurrently with the replacement property.

The payment and unconditional release of an earnest money deposit to the seller on a non-refundable basis may be sufficient to persuade the seller to cooperate. The seller may prefer an additional payment such as an option fee to extend the close of escrow, which could be cheaper than the Reverse 1031 Exchange transaction.

The seller may not be willing to cooperate in delaying the close of escrow, but perhaps would be interested in carrying back some financing in the short-term to assist the Investor with his Reverse 1031 Exchange transaction.

Exeter 1031 Exchange Services, LLC is always available to assist Investors with complex Reverse 1031 Exchange transactions. We would be happy to meet with the other parties involved with the Investor's Reverse 1031 Exchange such as the lender, accountant, attorney, and/or escrow officer, in order to assist in structuring the Reverse 1031 Exchange.

In any event, you should always seek the advice of competent legal, tax and financial counsel prior to entering into any 1031 Exchange transaction. Contact us for more complete information.

Definitions in an Exchange

1033 Exchange (Involuntary Conversion)

Section 1033 of the Internal Revenue Code provides that real or personal property subject to an involuntary conversion, either from an Eminent Domain proceeding (condemnation by the government) or destruction by a natural disaster, such as an earthquake, hurricane or fire, can be exchanged on a tax-deferred basis for “like-kind” real or personal property that is similar or related in service or use.

1034 Exchange (Repealed) 

Section 1034 of the Internal Revenue Code was repealed and replaced by Section 121 (see following) in 1997. The 1034 Exchange allowed you to sell your primary residence and defer or “rollover” your capital gain by acquiring another primary residence of equal or greater value.

121 Exclusion (Primary Residence)

The Taxpayer Relief Act of 1997 repealed and replaced the tax-deferral “rollover” provision of Section 1034 with the tax-free exclusion provision under Section 121 of the Internal Revenue Code. Generally, you can sell your primary residence and exclude from gross income up to $250,000 in capital gains ($250,000 per taxpayer, $500,000 for a married couple). You must have owned and lived in the property as your primary residence for at least a total of 24 months out of the last 60 months. 

453 Installment Sale (Seller Carry-Back Note)

Section 453 of the Internal Revenue Code allows you to sell real property and help your buyer finance the purchase of your property by carrying back an installment note (“seller carry-back financing”) while deferring the recognition and payment of your capital gain income tax liability until you receive principal payments. Depreciation recapture income tax liabilities cannot be deferred under Section 453 and are due and payable in the year in which you sold your relinquished property.

721 Exchange (upREIT or 1031/721)

Section 721 of the Internal Revenue Code allows you to exchange investment real estate for an interest in a Real Estate Investment Trust (“REIT”). This is also referred to as an upREIT, or 1031/721 Exchange.

1031 Exchange Benefits

Income Tax Consequences The sale of investment real estate may result in the recognition of ordinary income, capital gain, depreciation recapture and/or Medicare Surcharge (“Obamacare”) income tax liabilities. Payment of these income tax liabilities reduces the amount of cash available for reinvestment and makes it difficult for you to reinvest in larger, more profitable properties.

Using a 1031 Exchange, you can defer the payment of your income tax liabilities, keeping 100% of your cash working for you by reinvesting in replacement property. Exchanging Throughout Your Lifetime The 1031 Exchange is certainly a great transaction tool to defer the payment of your income tax liabilities when you sell investment real estate, but it is much more than that. It is also a great wealth building tool. It allows you to continually defer the payment of your capital gain and depreciation recapture income tax liabilities over your lifetime. This means that you continue exchanging properties as a life-long strategy, always deferring the payment of your income tax liabilities and keeping your equity working for you. Using this strategy, the value of your real estate portfolio, and consequently your net worth, will grow exponentially faster over your lifetime as you continually defer the payment of your income tax liabilities.

Step-Up In Cost Basis After your death, your heirs will inherit your property and receive a step-up in cost basis equal to the fair market value of the property at the time of your death. Your heirs can immediately sell the property without incurring any capital gain and/or depreciation recapture income tax liabilities.

1031 Exchange Structures From Simple to Complex

Forward 1031 Exchanges Simultaneous 1031 Exchanges The simultaneous (“concurrent”) 1031 Exchange is the most basic 1031 replacement properties. The relinquished property and the replacement property transactions all close on the same day in a simultaneous 1031 Exchange transaction. Delayed 1031 Exchanges Most Forward 1031 Exchange transactions are structured as Delayed 1031 Exchanges, where you sell your relinquished property first and then subsequently acquire your replacement property within the prescribed deadlines. We can help you and your legal, tax and financial advisors plan your Forward 1031 Exchange to comply with the requirements for identifying and acquiring replacement property.

Reverse 1031 Exchanges

On occasion, you may need or want to acquire your replacement property before you sell or list for sale your relinquished property. IRS Revenue Procedure 2000-37 allows this. This Revenue Procedure allows you to acquire your replacement property first and then sell your relinquished property later. This is accomplished by transferring, or “parking,” legal title to either your relinquished property or replacement property with an Exchange Accommodation Titleholder (“EAT”) in order to properly structure and complete a Reverse 1031 Exchange transaction.

There are two components to a Reverse 1031 Exchange transaction: 

  • A parking arrangement where an EAT acquires and holds or “parks” legal title to your relinquished property or your replacement property;
  • a Simultaneous 1031 Exchange, either at the beginning (“Exchange First”) or at the end (“Exchange Last”) of the Reverse 1031 Exchange transaction.

We can help you and your advisors structure your Reverse 1031 Exchange transaction by functioning as the EAT. We acquire and hold or “park” legal title to either your relinquished property in an Exchange First structure, or your replacement property in an Exchange Last structure, while you sell your relinquished property. Reverse 1031 Exchange transactions are very complicated. They require an experienced and knowledgeable Qualified Intermediary and Exchange Accommodation Titleholder to safely and successfully complete your transaction.

Improvement (Build-To-Suit) 1031 Exchanges 

You can use your 1031 Exchange funds to acquire replacement property, then build, construct or improve the replacement property through an Improvement 1031 Exchange (also known as a Construction or Build-To-Suit 1031 Exchange).

  • Your replacement property is acquired and held or “parked” by an Exchange Accommodation Titleholder while improvements are made to the property within the required 1031 Exchange deadlines.
  • Specific 1031 Exchange requirements must be adhered to in order to qualify for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code and Section 1.1031 of the Department of the Treasury Regulations.
  • Improvement 1031 Exchange transactions are complex.

They require an experienced and knowledgeable Qualified Intermediary and Exchange Accommodation Titleholder to safely and successfully complete your transaction. 1031 Exchange Administration

1031 Exchange Administration Working With Your Qualified Intermediary

The Role of the Qualified Intermediary (Accommodator) A professional, experienced, knowledgeable and financially sound Qualified Intermediary (“QI”) like Exeter 1031 Exchange Services, LLC, is critical to structuring and completing a successful 1031 Exchange transaction. Your Qualified Intermediary is responsible for a number of important roles in the administration of a successful 1031 Exchange transaction, including: (1) Preparing the 1031 Exchange legal agreements and related transaction documents to properly structure the 1031 Exchange; and (2) Receiving, holding and safeguarding your 1031 Exchange funds throughout the transaction; and (3) Consulting with you and your professional advisors regarding the implementation of your 1031 Exchange transaction to ensure compliance with all applicable Internal Revenue Codes, Treasury Regulations and related Revenue Rulings and Procedures.

Entrusting your 1031 Exchange funds to a Qualified Intermediary prevents you from having access to (actual receipt) or exercising control over (constructive receipt) your 1031 Exchange funds or assets, which would disqualify your 1031 Exchange transaction.

Choosing a Reliable Qualified Intermediary 

The Qualified Intermediary plays a critical role in the 1031 Exchange process. This is especially true when it comes to holding, managing and safeguarding your 1031 Exchange funds. The safety of your 1031 Exchange funds should be the most important part of your due diligence process. Therefore, it is crucial that you thoroughly evaluate prospective Qualified Intermediaries. Understand that Qualified Intermediaries, in general, are not licensed, regulated or required to be insured or bonded and have no minimum equity capitalization requirements. Exeter 1031 Exchange Services, LLC, however, is licensed, regulated, insured and bonded through its affiliate companies. We recommend that you consider the following risk criteria prior to selecting a Qualified Intermediary: (1) The technical expertise and experience of the Qualified Intermediary (2) The level of protection provided by the Qualified Intermediary’s errors and omissions insurance coverage, which protects you against possible mistakes made by the Qualified Intermediary (3) The level of protection provided by the Qualified Intermediary’s fidelity bond coverage, which protects you from potential theft or embezzlement of your 1031 Exchange funds by the Qualified The practice of using Qualified Trust Accounts or Qualified Escrow Accounts to ensure that your 1031 Exchange funds are protected by law as fiduciary funds (5) The protections provided through licensing, auditing, and regulatory oversight by regulatory authorities An experienced and professional Qualified Intermediary will understand these concerns and will be happy to discuss these issues with you. Prudent Qualified Intermediaries, like Exeter 1031 Exchange Services, LLC, will have already evaluated the applicable risks, addressed the critical issues, and implemented appropriate safeguards to protect your 1031 Exchange funds to ensure the successful completion of your 1031 Exchange transaction

Safeguarding Your 1031 Exchange Funds

Protecting your wealth is our highest priority. We have the expertise and experience to help you and your legal, tax and financial advisors successfully navigate the complexities of a 1031 Exchange transaction. While you are working on researching your next move, you can rest assured that your money is protected via the safeguards we have implemented on your behalf. Financial Strength, Bonding and Stability In addition to our extensive experience, expertise and depth of technical knowledge, we maintain significant levels of financial strength, including equity capital, bonding and insurance, providing the safety, stability and resources necessary to successfully and safely administer your 1031 Exchange transaction. Your 1031 Exchange funds are bonded, insured and protected with a multi-million dollar fidelity bond (per occurrence) and errors and omissions insurance policy, general liability insurance and significant equity capital. We would be happy to provide evidence of our bonding and insurance coverage to you. Qualified Trust Account Your 1031 Exchange funds are deposited, held and safeguarded in separate, segregated Qualified Trust Accounts. Qualified Trust Accounts ensure that your 1031 Exchange funds are protected by law as fiduciary assets. Qualified Use Property Your 1031 Exchange Properties Qualify if You Meet These Guidelines You must adhere to specific 1031 Exchange requirements in order to qualify for tax-deferred treatment under Section 1031 of the Internal Revenue Code and Section 1.1031 of the Department of the Treasury Regulations. Property Must Be Held For Investment Your relinquished properties and your replacement properties must satisfy the Qualified Use requirement. This means that your real property must be held for rental (income production), investment.

appreciation), or be used in your trade or business to qualify for 1031 Exchange treatment. Properties that are not held for investment (e.g., you’re holding them for sale or for personal use) will generally not qualify for 1031 Exchange treatment. For example, property acquired for repair and maintenance (e.g., rehab) with the intent to sell (flip) once repairs are completed, will be considered property held for sale (not held for investment) and will technically not qualify for 1031 Exchange treatment.

Intent to Hold for Investment Use is Critical You must be able to demonstrate that you had the intent to hold your relinquished and your replacement properties for rental, investment, or business use in the event you are audited. IRS Treasury Regulations do not require investment property to be held for any specific period of time for 1031 Exchange purposes. However, one of the best ways to demonstrate your intent to hold for rental, investment or business use is to do just that – hold your properties for a sufficient period of time so that you can easily prove your intent to hold for investment. Most 1031 Exchange experts and advisors recommend you hold property for at least 12 months to clearly demonstrate your intent to hold for investment purposes, although a number of IRS Rulings have alluded to 24 months. Holding your rental, investment, or business use property for less than 12 months does not mean that your 1031 Exchange will be disqualified, but it might be significantly more difficult to prove your intent to hold for investment purposes under an audit.

Like-Kind and Non-Like-Kind Property

The relinquished and replacement properties that are part of the same 1031 Exchange transaction must also satisfy the like-kind property requirement to qualify for 1031 Exchange treatment. Real estate will be considered like-kind property as long as all of your relinquished properties and replacement properties satisfy the Qualified Use requirement. This means that any real property will be considered like-kind to any other real property as long as all of the properties are held for investment purposes as discussed above.

Like-Kind Property

The following types of properties are representative of those that will generally qualify as like-kind real property:

  • Single-family residential properties
  • Multi-family residential properties
  • Commercial office buildings 
  • Retail shopping centers or strip malls
  • Industrial warehouses 
  • Vacant, undeveloped, or raw land 
  • Farm, ranch or timber land 
  • Oil and gas interests
  • Mineral rights 
  • Water rights 
  • Air rights 
  • Tenant-in-common (TIC) investment properties (fractional interests) 
  • Delaware Statutory Trust (DST) investment properties (fractional interests) 
  • Properties held in Title Holding Trusts/Land Trusts (beneficial interests) 
  • Vacation rentals (see section on vacation properties)

You can exchange between any of the asset classes referenced above as long as you satisfy the Qualified Use requirement.

Non-Like-Kind Property

Certain types of properties are specifically excluded and are not considered to be qualified use and/or like-kind property for 1031 Exchange treatment. They include property held for personal use or sale (inventory), securities or security interests, and interests in an entity. Here is a detailed list:

Personal Use Assets

  • Primary residences 
  • Second homes
  • Vacation homes (personal use) *See section on second homes and vacation properties

Property Held For Sale

  • Property held for development and then subsequent sale 
  • Property acquired for conversion, then sale (e.g., condo conversions)
  • Property acquired to fix-up or rehab and sell (flip) Securities
  • Cash 
  • Stocks 
  • Bonds
  • Mutual funds
  • Real Estate Investment Trusts (REITs) (except via an upREIT) Interests in an Entity 4 Partnership interests in a general or limited partnership
  • Membership interests in a limited liability company (unless it is considered to be a disregarded entity such as a single-member LLC) 
  • Shares of stock owned in a “C” or “S” corporation

Vacation Properties and Second Homes

You can 1031 Exchange your vacation property or second home provided that you follow the safe harbor guidelines outlined in IRS Revenue Procedure 2008-16. The subject property must be held as investment property for at least 24 months, must be rented for a minimum of 14 days each year during the 24 months, and cannot personally be used for more than 14 days or 10% of the total number of days per year that you rented the property.

Domestic or Foreign Property

Real property sold in one state may be exchanged for like-kind real property located in another state provided the properties are both located within the United States (i.e., they are all domestic like-kind real properties). You can only 1031 Exchange domestic (United States) real property for like-kind domestic real property. Non-domestic (foreign) real property can only be exchanged for like-kind non-domestic real property. Domestic real property cannot be exchanged for non-domestic real property because they are not considered to be like-kind.

1031 Exchange Deadlines

Time Matters When Completing a 1031 Exchange To successfully complete your 1031 Exchange, you must meet certain deadlines. These deadlines include the 45-calendar day identification deadline and the 180 calendar day 1031 Exchange deadline. These deadlines cannot be extended under any circumstances unless the properties or taxpayer involved in the 1031 Exchange are located within a natural disaster area designed by the President of the United States.

45 Calendar Day Identification Period

You have 45 calendar days to identify your potential replacement property. It should be identified to your Qualified Intermediary no later than midnight of the 45th calendar day following the close of your relinquished property sale transaction. This deadline is exactly 45 calendar days. If the 45th calendar day lands on a Saturday, Sunday or legal holiday, the deadline is not extended to the next business day. You can change your mind by formally revoking your identification of the replacement property and submitting another identification form at any time during your 45-calendar day identification period. You cannot change your mind after the 45th calendar day.

180 Calendar Day 1031 Exchange Period

You must complete your 1031 Exchange transaction, which includes the receipt of legal title to all replacement properties to be acquired, no later than the earlier of: (1) midnight of the 180th calendar day following the close of the relinquished property sale transaction, or (2) the due date to file your Federal income tax return for the income tax year in which the relinquished property was sold, including any extensions of time to file.

Identification Requirements

Identifying Replacement Property

There are very specific requirements for identifying potential replacement properties in your 1031 Exchange transaction. Your identified replacement properties do not need to be under contract or in escrow. Replacement properties must be clearly and unambiguously identified to your Qualified Intermediary using one or more of the following property descriptions: (1) Street address (2) Legal description (3) Assessor’s Parcel Number (APN)

You must comply with at least one of the following identification rules when identifying your replacement properties.

Three Property Identification Rule

This rule limits the number of replacement properties you can identify to not more than three (3) possible replacement properties. There is no limit on the market value of these three identified properties. This is the most common identification rule used today. In most cases you will identify three potential replacement properties with the intent to acquire one of the three. The second and third identified properties serve merely as backup properties in the event that you cannot acquire your first identified property. You could certainly acquire all three identified properties as part of your 1031 Exchange transaction. You can ignore the three property identification rule and comply with the 200% of fair market value (FMV) rule instead if you wish to identify more than three potential replacement properties. 200% of FMV Identification Rule The 200% of fair market value identification rule allows you to identify more than three potential replacement properties as long as the combined fair market value of the identified properties does not exceed 200% of the gross sale price of the relinquished property sold in your 1031 Exchange transaction.

There is no limit on the number of identified properties; only on the fair market value. For example, if you sold relinquished property with a gross sale price of $2,000,000, you can identify as many potential replacement properties as you want as long as the total value of the identified properties does not exceed $4,000,000 (200% X $2,000,000).

95% Identification Exception

The 95% exception allows you to identify more replacement properties than allowed under the first two identification rules. There is no limit to the total number or total value of identified replacement properties under the 95% exception as long as you actually acquire and close on at least 95% of the total fair market value identified.

Completing Your 1031 Exchange

Your Guide to a Successful 1031 Exchange

You should always consult with your legal, tax and financial advisors before completing any real estate or income tax related transaction to ensure compliance with all codes, regulations, and rulings. No one knows your circumstances better than your professional advisors. Deferring 100% of Your Income Taxes In order to defer all of your Federal, and in most cases, state, capital gain and depreciation recapture income taxes on the sale of investment property, you must meet certain reinvestment requirements. Generally, to defer all of your income tax liabilities, you must do the following:

  • Acquire one or more replacement properties that are equal to or greater than the value of the relinquished property that you sold (based on the net sale price, not equity or gain)
  • Reinvest all of your net cash proceeds (net equity) received from the sale of your relinquished property
  • Replace the amount of debt paid off on the sale of your relinquished property with new debt or additional out-of-pocket cash of an equal amount on the replacement properties you acquire

You can always put more cash into your replacement property transactions. You cannot pull any cash out of your relinquished property sale transaction without incurring an income tax liability.

Permissible and Non-Permissible Selling Expenses

1031 Exchange proceeds can be used to pay for certain routine selling expenses related to the sale of the relinquished property and for certain routine purchase costs related to the acquisition of the replacement property without creating an income tax liability. However, if 1031 Exchange proceeds are used to pay for operating costs, financing (lender) related charges, or other non-routine selling expenses, you will recognize some income tax liability.

The more common permissible and non-permissible 1031 Exchange selling expenses, closing or settlement costs and charges are listed below. Routine permissible and non-permissible 1031 Exchange selling expenses and closing or settlement costs can vary by geographic region based on common practices, local standards and customs.

Permissible Selling Expenses and Closing Costs

  • Owner’s title insurance premiums 
  • Escrow agent’s, settlement agent’s, or closing attorney’s fees
  • Real estate broker’s commissions 
  • Finder fees or referral fees 
  • 1031 Exchange Qualified Intermediary’s fees 
  • Documentary transfer taxes
  • Recording or filing fees
  • Attorney’s fees and costs directly related to the transaction 
  • Tax advisor’s fees directly related to the transaction Non-Permissible Operating Expenses, Financing and Closing Costs
  • Financing or lender costs such as loan fees, loan points, appraisal fees, mortgage insurance premiums, lender’s title insurance policy premiums, and other loan processing fees and costs 
  • Prorated property taxes
  • Prorated rents 
  • Insurance premium payments
  • Security deposits 
  • Payoff of credit card balances
  • Repairs and/or maintenance costs

You should always review a copy of your estimated closing or settlement statement with your tax advisor prior to any closing.

Partial Tax Deferral

You can complete a partial 1031 Exchange transaction by trading down in value or by pulling cash out. The amount that is not exchanged for qualified replacement property is called cash boot or mortgage boot and will generate income tax liabilities.

Exchanging Multiple Properties and Fractional Interests

You can sell multiple relinquished properties and/or purchase multiple replacement properties as part of your 1031 Exchange transaction. Your 1031 Exchange is not limited to one relinquished property and/or one replacement property. The relinquished and/or replacement properties can also involve the sale or purchase of a fractional interest, which means you do not have to acquire and/or own 100% of the property.

Seller Carry-Back Financing

We advise our clients to plan carefully if they intend to sell a relinquished property with a seller carry-back note when completing a 1031 Exchange transaction. You must decide whether you want to include or exclude the seller carry-back note inside your 1031 Exchange before the close of sale of your relinquished property. The installment note and deed of trust or mortgage will be drafted differently depending on which strategy you select. Seller carry-back financing can significantly complicate your 1031 Exchange transaction. Consult with your advisors before you finalize the terms of your transaction.

Assignment of the Purchase and Sale Agreement

In order to defer all of your income tax consequences, you must select your Qualified Intermediary, and have the Purchase and Sale Agreement and any related Escrow Instructions (if applicable) assigned to your Qualified Intermediary, before the close of your relinquished property.

Transactions that close without a 1031 Exchange set-up prior to closing will be taxable because you have the right to the net proceeds.

Early Release of Funds before Closing

Purchase and Sale Contracts often provide for early release (payment) of earnest money deposits, extension payments, option payments, or other funds before the close of the relinquished property sale transaction. If the early release has not been structured properly, early release payments can result in taxable boot even when the transaction has been structured as a 1031 Exchange. We always recommend you first have your Qualified Intermediary assigned into your relinquished property sale transaction, and then have the funds released to your Qualified Intermediary.

Taxpaying Entity

Generally, the replacement property must be acquired by the same taxpaying entity that sold the relinquished property. There are some exceptions to this rule such as entities that are classified as disregarded entities. Consult with your legal and tax advisors for more information.

Entity Breakup Issues

Taxpaying entities of all types, including “C” Corporations, “S” Corporations, General and Limited Partnerships, Multi-Member Limited Liability Companies, and Revocable and Irrevocable Trusts can defer the payment of their income tax liabilities through a 1031 Exchange transaction. Significant tax planning problems arise when the taxpaying entity selling the relinquished property is dissolving and the underlying owners (stockholders, partners or members) want to go separate directions. If you own investment real estate inside of an entity, it is critical that you discuss your exit strategy today with your legal, tax and financial advisors, so that you avoid any last-minute tax planning problems.

Related Party Issues

Related party 1031 Exchange transactions occur when you sell your relinquished property to, or you buy your replacement property from, a related party. Related party 1031 Exchanges might qualify provided you comply with specific regulations and rulings issued by the Internal Revenue Service. The relinquished property sold to a related party or the replacement property acquired from a related party must be held for at least two years in order to qualify for 1031 Exchange treatment. Replacement properties acquired from a related party have additional requirements outlined in Revenue Ruling 2002-83 and will often not qualify for 1031 Exchange treatment.

Access to Your 1031 Exchange Funds

IRS Treasury Regulations and Rulings allow you to access your 1031 Exchange funds only when you have met one of the following conditions:

  • Your 45 calendar day identification period has expired and you did not identify any replacement properties; or
  • You have purchased all of your identified replacement properties and your 45 calendar day identification period has expired; or 
  • Your 180 calendar day 1031 Exchange period has expired.

Cooperation Clauses for Purchase and Sale Contracts

Here is suggested language for a Cooperation Clause for your Purchase and Sale Agreements that you and your advisors can use and/or modify as needed: Relinquished Property (Sale): Buyer acknowledges that Seller intends to perform a tax-deferred exchange transaction pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations and that Seller’s rights, title and interest (but not obligations) pursuant to this [Insert Name of Purchase and Sale Agreement or Sales Contract or Escrow Instructions] will be assigned to Exeter 1031 Exchange Services, LLC, as Seller’s Qualified Intermediary, for the purpose of completing Seller’s 1031 Exchange transaction. Buyer agrees to cooperate with Seller at no additional cost or liability to Buyer, by executing the documents necessary to complete Seller’s 1031 Exchange transaction. Replacement Property (Purchase): Seller acknowledges that Buyer is completing a tax-deferred exchange transaction pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations and that Buyer’s rights, title and interest (but not obligations) pursuant to this [Insert Name of Purchase and Sale Agreement or Purchase Contract or Escrow Instructions] will be assigned to Exeter 1031 Exchange Services, LLC, as Buyer’s Qualified Intermediary, for the purpose of completing Buyer’s 1031 Exchange transaction. Seller agrees to cooperate with Buyer and Exeter 1031 Exchange Services, LLC, at no additional cost or liability to Seller, by executing the documents necessary to complete Buyer’s 1031 Exchange transaction.

Replacement Property Purchase in a Reverse 1031 Exchange: 

Seller acknowledges that Buyer is completing a Reverse 1031 Exchange transaction, pursuant to Section 1031 of the Internal Revenue Code, Section 1.1031 of the Treasury Regulations, and Revenue Procedure 2000-37, and that Buyer’s rights, title and interest (but not obligations) pursuant to this [Insert Name of Purchase and Sale Agreement or Purchase Contract or Escrow Instructions] will be assigned to a new limited liability company formed by Exeter Reverse 1031 Exchange Services, LLC, as Buyer’s Exchange Accommodator Titleholder, for the sole purpose of completing Buyer’s Reverse 1031 Exchange transaction. Seller agrees to cooperate with Buyer and Exeter Reverse 1031 Exchange Services, LLC, at no additional cost or liability to Seller, by executing the documents and deeds necessary to complete Buyer’s Reverse 1031 Exchange transaction, including an Assignment, Acknowledgment, Notice, and Direction to Convey the property into the new limited liability company. Consult with your legal and tax advisors in order to properly adapt the above language to your specific transaction.

Step-By-Step Instructions to Complete 1031 Exchange 

The following is a general checklist for completing your 1031 Exchange transaction:

Relinquished Property 

  • Consult with your legal, tax and financial advisors before proceeding 
  • Notify your real estate agent and escrow or closing agent that you will be completing a 1031 Exchange
  • Insert Cooperation Clause language into your Purchase and Sale Agreement and/or Escrow Instructions (see suggested language discussed above) 
  • Contact and retain your Qualified Intermediary to open your 1031 Exchange 
  • Provide your complete contact information, including government issued photo identification and entity formation documents 
  • Notify if you’re going to be withdrawing any cash from your 1031 Exchange 
  • Notify if there will be a seller carry-back note in your 1031 Exchange 
  • Notify if there will be any construction involved on your replacement property as part of your 1031 Exchange 
  • Execute your 1031 Exchange documents
  • Review closing/settlement statement for potential taxable boot issues with your legal and tax advisors and prior to closing 
  • Notify  when your relinquished property sale transaction closes 
  • Look for written notification from Exeter when we receive your 1031 Exchange proceeds

Replacement Property

  • Consult with your legal, tax and financial advisors before proceeding 
  • Mail, email, fax or hand-deliver your signed replacement property identification form to Exeter within your 45 calendar day identification period 
  • Notify your real estate agent and escrow or closing agent that you are completing a 1031 Exchange 
  • Insert Cooperation Clause language into your Purchase and Sale Agreement and/or Escrow Instructions (see suggested language discussed above
  • Advise of the specific replacement property on your list of identified properties that you will be acquiring and who will be handling the closing 
  • Execute your 1031 Exchange documents
  • Notify  if you wish to have the earnest money deposit paid from your 1031 Exchange account 
  • Review closing/settlement statement for potential taxable boot issues with your legal and tax advisors prior to closing
  • Authorize to disburse your funds to your escrow or closing agent to complete your 1031 Exchange transaction

Special Tax Planning Strategies

Getting the Most Out of a 1031 Exchange Transaction

Combining a 1031 Exchange with a 121 Exclusion You can combine a 1031 Exchange with a 121 Exclusion. There are a number of possible scenarios for this.

Rental Property Converted to a Primary Residence (Prorated Exclusion Applies) 

The first scenario is that you own rental property that you acquired outright (i.e., it was not part of a prior 1031 Exchange transaction).

  • You decide to convert it into your primary residence so that you can take advantage of a prorated $250,000 tax-free exclusion per person ($500,000 for a married couple) via the 121 Exclusion. 
  • You are required to move into the investment property (i.e., convert it to your primary residence) and live there for at least 24 months. 
  • After 24 months you can sell the property and you will qualify for a prorated 121 Exclusion. The proration is calculated based on the number of years the property was used as rental property versus the number of years the property was used as your primary residence.

Remember that the 121 Exclusion will only exclude capital gains from your taxable income; it does not exclude any depreciation recapture.

Rental Property Acquired via a 1031 Exchange and Converted to a Primary Residence (Prorated Exclusion Applies)

The second scenario is virtually identical to the first scenario except that you acquired the investment property as part of a prior 1031 Exchange transaction. In this case, because you acquired the property as the replacement property in a prior 1031 Exchange, you should hold the property as investment property for a sufficient period of time to demonstrate that you had the intent to hold the property for investment purposes. You would then move into the investment property after the holding period in order to convert it to your primary residence, living in it for at least 24 months

There is one more requirement in this case. That is, you must hold or own the property for a minimum of five years before you can qualify for the 121 Exclusion. This is because you started off with a 1031 Exchange. You do not have to live in the property for five years, but you must own it for at least five years.

Primary Residence Converted to a Rental Property (Exclusion Not Prorated)

The third scenario is the complete opposite: you and your spouse own and live in a property as your primary residence. The challenge is that your capital gain significantly exceeds $500,000. You want to sell your home but the 121 Exclusion would only exclude the first $500,000 in capital gain from your taxable income with the balance of the capital gain subject to taxation. The Internal Revenue Service issued Revenue Procedure 2005-14, which allows you to move out of your primary residence and convert it into investment property. The question is: how long must you hold the property as investment property? Based on Revenue Procedure 2008-16, we recommend that our clients hold the property for investment for at least 24 months or more to demonstrate that they have the intent to hold for investment. Once you have held the property for investment for at least 24 months, you can sell it and qualify for a combined 121 Exclusion and 1031 Exchange strategy. You would sell the property, exclude the full $500,000 in capital gains from your taxable income, and complete a 1031 Exchange on the balance of the transaction to defer the rest of your capital gain, including any depreciation recapture, into the purchase of another rental property. This tax planning strategy must be completed no later than three years from the date that you moved out of your primary residence and converted it into investment property. Combined 121 Exclusion and 1031 Exchange on Split-Use Property The final scenario can encompass many variations on the same theme. You own property that is held for investment or used in your business and it is also your primary residence. This is what we refer to as split-use property.

You can take advantage of the 121 Exclusion and the 1031 Exchange, provided you qualify for both income tax planning strategies. Essentially the property will be allocated or divided between investment use and your primary residence portion on the basis of square footage, acreage or another acceptable allocation method, and you complete a split-use transaction.

Combined 121 Exclusion and 1031 Exchange strategies can be complicated. Consult with your legal, tax and financial advisors before proceeding. Installment Sale Treatment for Failed 1031 Exchanges Depending on when you have the right to access your 1031 Exchange funds, you may still be able to defer your capital gain into the following income tax year if your 1031 Exchange fails. Depreciation recapture cannot be deferred into the following income tax year if your 1031 Exchange fails. Depreciation recapture taxes are due in the taxable year in which you sold your relinquished property

Identifying and Evaluating Critical Risks

The critical risk criteria that you must review and evaluate prior to making your final decision on which 1031 Exchange Qualified Intermediary to retain includes, but is not limited to, the following areas:

  1. Technical capability of the 1031 Exchange Qualified Intermediary
  2. Internal processes and audit controls to safeguard your 1031 Exchange funds and assets
  3. Use of Qualified Trust Accounts or Qualified Escrow Accounts
  4. Decision criteria and guidelines for investment of your 1031 Exchange funds
  5. Protection from potential errors or omissions by the Qualified Intermediary
  6. Protection from potential theft or embezzlement of 1031 Exchange funds

An experienced and professional 1031 Exchange Qualified Intermediary will understand these concerns and should be happy to discuss these crucial issues with you. And, well managed institutional 1031 Exchange Qualified Intermediaries like Exeter 1031 Exchange Services, LLC will have already evaluated the applicable risks, addressed the critical issues and implemented appropriate safeguards to protect your 1031 Exchange funds to ensure the successful completion of your 1031 Exchange transaction.

The following comments will provide specific and acceptable industry guidelines and standards that will be helpful in evaluating 1031 Exchange Qualified Intermediaries and in determining if acceptable and adequate controls and safeguards are being practiced. You should never take short-cuts when evaluating and selecting a 1031 Exchange Qualified Intermediary for your 1031 Exchange transaction; to do so could have disastrous consequences.

Securitized 1031 Programs this also previously

Securitized Passive income 1031 Programs

Three limited options for “1031’s” in disposing of appreciated real estate:

  1. Sell the property and pay taxes. Upwards to 30% or more profit may be due in taxes in addition to a recapture of depreciation at a 25% rate and 3.8% Medicare Tax.
  2. Sell property to exchange into another like property.
  3. Sell the property and exchange into owning partial ownership of commercial properties.
    • Passive ownership
    • No management responsibilities
    • Receive potential projected monthly income
    • Current income tax benefits
    • Potential appreciation of the properties

“Delaware Statuary Trust”

Two Financial Suitability Requirements to Be an Accredited Investor. (to qualify for a DST)

  1. Income: For single income for last two years and current year of $200,000. For married, $300,00 OR,
  2. Net Worth: $1 million Net Worth exclusive of home & furnishing

STEPS in a 1031 Tax-Deferred (DST) Exchange Process

  1. Meet with financial advisor to consider all your options.
  2. Check with your accountant to provide a tax analysis reflecting the amount of taxes which will be due if an exchange is not elected.
  3. If your property is listed make sure all aware that you have decided to do a 1031 exchange.
  4. Establish an Accommodator/Qualified Intermediary to establish an account for the transfer. (see below)
  5. Set up escrow to reflect the exchange
  6. When escrow closes, net funds are wired to your “Qualified Intermediary” account.  “If Your QI account is not set up and escrow closes and YOU receive the funds, you will pay taxes!
  7. You now have 45-days to identify replacement properties and another 135 days which to close escrow.
  8. Delaware Statuary Trust closing can generally be completed within an approximate two-week period or less depending on availability.
  9. A diversified portfolio of property sponsors should be considered. Due to regulatory requirements, there are concentration restrictions of amount which can be allocated to a sponsor or a property.

Identifying and Evaluating Critical Risks

The critical risk criteria that you must review and evaluate prior to making your final decision on which 1031 Exchange Qualified Intermediary to retain includes, but is not limited to, the following areas:

  1. Technical capability of the 1031 Exchange Qualified Intermediary
  2. Internal processes and audit controls to safeguard your 1031 Exchange funds and assets
  3. Use of Qualified Trust Accounts or Qualified Escrow Accounts
  4. Decision criteria and guidelines for investment of your 1031 Exchange funds
  5. Protection from potential errors or omissions by the Qualified Intermediary
  6. Protection from potential theft or embezzlement of 1031 Exchange funds

An experienced and professional 1031 Exchange Qualified Intermediary will understand these concerns and should be happy to discuss these crucial issues with you. And, well managed institutional 1031 Exchange Qualified Intermediaries like Exeter 1031 Exchange Services, LLC will have already evaluated the applicable risks, addressed the critical issues and implemented appropriate safeguards to protect your 1031 Exchange funds to ensure the successful completion of your 1031 Exchange transaction.

The following comments will provide specific and acceptable industry guidelines and standards that will be helpful in evaluating 1031 Exchange Qualified Intermediaries and in determining if acceptable and adequate controls and safeguards are being practiced. You should never take short-cuts when evaluating and selecting a 1031 Exchange Qualified Intermediary for your 1031 Exchange transaction; to do so could have disastrous consequences.