Reverse and improvement exchanges

Why a reverse exchange exists

An owner who finds a replacement property before a buyer is lined up for the relinquished property runs into a timing gap that a forward exchange cannot close. Section 1031 and the deferred-exchange regulations at Treas. Reg. §1.1031(k)-1 assume a sequence: the relinquished property sells first, and the qualified intermediary holds the proceeds until the exchanger buys replacement property within the 45- and 180-day windows described in the guide to what a 1031 exchange is. When events run the other way, the exchanger cannot simply buy the replacement property directly and exchange into it afterward. The deferred-exchange regulations do not cover an exchanger who acquires the replacement property before transferring the relinquished property. Rev. Proc. 2000-37 provides a safe harbor for doing so through an exchange accommodation titleholder, but not for property the exchanger itself owned in the prior 180 days (Rev. Proc. 2004-51).

A reverse exchange solves the ordering problem without asking the exchanger to give up the replacement property or rush the sale of the old one. Instead, a party other than the exchanger holds legal title to one of the two properties for a limited period while the rest of the transaction catches up.

The safe harbor: Rev. Proc. 2000-37

Rev. Proc. 2000-37, as modified by Rev. Proc. 2004-51, describes conditions under which the IRS will treat a reverse exchange as valid without inquiring further into who holds beneficial ownership of the parked property. At the center of the safe harbor is an exchange accommodation titleholder, or EAT: an entity that takes legal title or other qualified indicia of ownership (often the membership interest in a single-member LLC that holds title) to either the replacement property or the relinquished property while the exchanger arranges the other side of the transaction. The EAT cannot be the exchanger or a disqualified person.

Exchange last and exchange first

Two arrangements fit inside the safe harbor. In the more common structure, often called exchange last, the EAT takes title to the replacement property first, using financing the exchanger arranges or a loan from the exchanger, and holds it until the relinquished property sells; the EAT then transfers the replacement property to the exchanger to complete the exchange. In the less common exchange first structure, the EAT takes title to the relinquished property while the exchanger buys the replacement property directly, and the EAT later transfers the relinquished property to the ultimate buyer.

The qualified exchange accommodation agreement

The EAT and the exchanger must enter into a qualified exchange accommodation agreement, or QEAA, within five business days of the EAT taking title to the parked property. The QEAA states that the EAT is holding the property to facilitate an exchange under section 1031 and Rev. Proc. 2000-37. The QEAA must also specify that the EAT is treated as the beneficial owner of the property for all federal income tax purposes while it holds it, and both parties report consistently with that agreement.

The 180-day limit and the 45-day identification

The safe harbor caps how long an EAT may hold parked property at 180 days from the date title transfers to the EAT. The combined time that the relinquished property and the replacement property are held under the QEAA also cannot exceed 180 days. If the exchange is not completed within that period, the arrangement falls outside Rev. Proc. 2000-37 and loses the benefit of the safe harbor.

When the replacement property is the one parked with the EAT, the exchanger must still identify the relinquished property in a signed writing delivered within 45 days of the EAT taking title, following the same identification mechanics described in the guide to the 45- and 180-day deadlines. The identification runs against the property being sold rather than the property being bought, but the deadline behaves the same way: a fixed number of calendar days from day zero, with no routine extensions.

What the exchanger may do while the property is parked

Rev. Proc. 2000-37 §4.03 lists arrangements that do not disqualify the safe harbor even though, at first glance, they look like the exchanger is controlling the parked property. The exchanger may guarantee obligations related to the parked property, loan money to the EAT to fund the acquisition or improvements, indemnify the EAT against loss, and lease, manage, or supervise the property while the EAT holds title. These permitted arrangements are what make the structure workable: without them, financing and managing a property that a special-purpose entity technically owns would be impractical.

Who the EAT is

The EAT is often a special-purpose entity, commonly a single-member LLC, formed to hold the parked property and nothing else. Because it exists only for the exchange, it has no operating history, no other assets, and no other obligations, which keeps the accommodation contained and limits what a lender or title company needs to review before working with the arrangement.

Financing and cost

A reverse exchange is generally more expensive to run than a forward exchange, because it adds an EAT entity, a qualified exchange accommodation agreement, and an intermediate transfer of title. Financing can also be more involved: a lender that would ordinarily lend to the exchanger directly must instead lend to the EAT, secured by a property the exchanger does not yet hold title to, and not every lender is set up for that. An exchanger considering a reverse exchange should raise financing with a lender familiar with the structure early, and budget for added cost relative to a forward exchange.

Reverse exchanges outside the safe harbor

Some reverse exchanges fall outside Rev. Proc. 2000-37, most often because the parking arrangement runs longer than 180 days. These structures are not automatically invalid: in Bartell v. Commissioner, the Tax Court accepted, on its facts, a parking arrangement that predated Rev. Proc. 2000-37 and would have exceeded its 180-day limit. An exchange outside the safe harbor does not have the benefit of the IRS's assurance that it will not look behind the arrangement, so it carries more uncertainty than one that fits inside Rev. Proc. 2000-37, and it is not a routine planning option.

Improvement exchanges

An improvement exchange, sometimes called a construction or build-to-suit exchange, uses the same EAT mechanism to let exchange funds pay for construction or renovation on the replacement property before the exchanger takes title. The EAT holds the replacement property while the work is done, exchange funds are disbursed for construction, and the EAT transfers the improved property, land plus whatever has been built, to the exchanger within the 180-day period.

What counts toward the exchange

Only the improvements actually completed and in place at the time the property is transferred to the exchanger count as replacement property value. Under Treas. Reg. §1.1031(k)-1(e), the exchanger's 45-day identification must describe the improvements to be constructed, in addition to the land, in as much detail as is practicable at the time it is made. Work that is contracted for but not yet built, or exchange funds not yet spent when the 180-day period ends, does not carry over as replacement property and can leave the exchanger with boot.

The "own property" problem

Exchange funds can generally be used to improve property the exchanger does not yet own; they generally cannot be used to improve property already titled in the exchanger's name. This limitation traces to a line of authority including Bloomington Coca-Cola Bottling Co. v. Commissioner and Rev. Rul. 67-255, which treat improvements to property the taxpayer already holds as the taxpayer's own spending rather than an exchange for like-kind property. That is why the EAT, not the exchanger, holds title during construction: once title passes to the exchanger, further improvement spending falls outside the exchange. The safe harbor also does not apply to property the exchanger owned at any time in the 180 days before the EAT acquires it (Rev. Proc. 2004-51).

Combined reverse-improvement structures

The two structures are sometimes combined: the EAT acquires the replacement property in a reverse exchange before the relinquished property has sold, and construction or renovation proceeds on the parked property while the sale of the relinquished property is still pending. A combined reverse-improvement exchange carries the requirements of both structures at once, including the 180-day parking limit and the requirement that improvements be in place before the exchanger takes title. It is generally the most involved version of the transactions described in this guide.

Sources

• Rev. Proc. 2000-37, as modified by Rev. Proc. 2004-51 (reverse exchange safe harbor, exchange accommodation titleholder, qualified exchange accommodation agreement).
• Treas. Reg. §1.1031(k)-1(e) (identification of property to be produced) and §1.1031(k)-1(g)(6) (restrictions on exchange funds).
• Internal Revenue Code §1031.
• Bartell v. Commissioner, 147 T.C. 140 (2016).
• Bloomington Coca-Cola Bottling Co. v. Commissioner, 189 F.2d 14 (7th Cir. 1951); Rev. Rul. 67-255.