WHEN IS A REVERSE ExchangeNOT AN Exchange

For the first time, property owners wishing to utilize the opportunity to pay no capital gains tax through Section “1031” of the Internal Revenue Code, have the ability to acquire the replacement property before disposing of the relinquished property.  

In a normal plain vanilla deferred Exchangetransaction, the taxpayer must come out of legal title of the relinquished property first and then within 180 days go into legal title of the replacement property in which this whole process is handled through a professional qualified intermediary.

On September 15, 2000, the Internal Revenue Service enacted revenue Procedure 2000-37 (reverse procedure), which was published as Internal revenue Bulletin 2000-40 on October 2, 2000, allowing for what’s referred to as a “reverse Exchange”. The safe harbor is available to all qualifying reverse Exchanges entered into on or after September 15, 2000.  

Today, owners of investment or business-held property can take advantage of a reverse Exchangewithout the scrutiny of the I.R.S. They must however adhere to the rules set forth in the new revenue procedure. This concept of acquiring the replacement property before disposing of the relinquished property and paying no capital gains tax, can be very helpful for many reasons. The primary reason is the taxpayer doesn’t want to miss out on the replacement property not being available, because they haven’t disposed of their relinquished property yet.  

The problem that we are seeing in the market place is that taxpayers are acquiring the replacement property by going into legal title themselves and are going to the professional qualified intermediary to structure their transaction as a reverse Exchange. This does not qualify as a reverse Exchange. The revenue procedure specifically states that legal title of the replacement property at all times must not be held by the taxpayer or an agent of the taxpayer. 

Variation No.1

There are two variations of how a “reverse Exchange” can be structured. The first is when the qualified intermediary (Exchangeaccommodation titleholder) goes into title of the replacement property.  The steps involved in this type of a reverse Exchangeare as follows: the taxpayer finds a replacement property, hires a professional qualified intermediary who is in the business of facilitating real estate Exchangetransactions, who then acquire legal title of the replacement property. Under the revenue procedure the qualified intermediary is referred to as the Exchangeaccommodation titleholder. 

The qualified intermediary (Exchangeaccommodation titleholder), goes into legal title of the replacement property not the taxpayer or an agent of the taxpayer. This means their real estate agent/broker, accountant/cpa, or their attorney would all be deemed an agent. A written Exchangeagreement must be entered into between the taxpayer and the qualified intermediary (Exchangeaccommodation titleholder) within five days of this point.

The relinquished property must be identified within 45 days, known as the (identification period) from the conveyance of legal title of the replacement property to the qualified intermediary (Exchangeaccommodation titleholder). Like a “deferred Exchange”, within 180 days known as the (Exchangeperiod) from the date of acquisition of the replacement property by the qualified intermediary (Exchangeaccommodation titleholder), the relinquished property must be conveyed to the buyer and the replacement property must be conveyed to the taxpayer from the qualified intermediary (Exchangeaccommodation titleholder), which will complete the reverse Exchangetransaction.  

This type of a reverse Exchangeis typically used when the taxpayer is purchasing the replacement property for cash, or the seller of replacement property is financing the acquisition. 

Variation No. 2

The second variation of a reverse Exchangeis when the qualified intermediary (Exchangeaccommodation titleholder) goes into legal title of the relinquished property which jump starts the Exchangetransaction like a normal plain vanilla deferred Exchange, allowing the taxpayer to go into legal title of the replacement property directly. This variation is typically used when the taxpayer is obtaining conventional financing for the replacement property and the lender requires the taxpayer to go into legal title of the replacement property directly. The problem of timing of the closing of the relinquished property and that of the replacement property is overcome with this variation  As with any Exchangetransaction, it is always advisable to consult with a professional qualified intermediary prior to proceeding.