Reverse Exchanges: Buy Before You Sell
What do you do when you find yourself in a circumstance where you want to do a 1031 exchange, but you also need to buy before you sell? The answer is a reverse exchange.
You may already be aware that the IRS prohibits you from exchanging into property you already own correct? So just doing a backwards exchange by buying the Replacement Property first and then selling your Relinquished Property isn't going to work.
So, the way in which a success reverse exchange is accomplished is by utilizing an Exchange Accommodation Titleholder (EAT) to temporarily hold title in the stead of the Exchanger. The EAT is a Limited Liability Company the Facilitator creates to hold title to one of the properties in your reverse exchange. We mention that the EAT holds title to one of the properties, because it can actually warehouse or park the title to either the new or old property, depending upon your sale circumstances.
Probably ninety percent of the time, reverses are accomplished by the EAT, with the aid of a loan from the Exchanger, acquiring the replacement property and holding the property title until such a time as the relinquished property is sold. Then at this point, the Exchanger's loan is repaid and the exchange can be completed by deeding the new property to the Exchanger. This is known as an Exchange Last reverse exchange.
However, it is also possible for the EAT to hold title to the relinquished property. This is known as an Exchange First reverse exchange. This approach allows the Exchanger to deed the old property to the EAT and continue with the purchase of the replacement property.
Now, this Exchange First approach is more difficult because the Exchanger must do a couple of things which are important. First, the Exchanger must balance the property equities which means they must ensure that there is approximately the same amount of equity in the new property as what will be coming out of the old property when it sells. Secondly, the Exchanger must be prepared to pay for some additional transfer taxes and closing costs when the old property is deeded from the EAT to the new buyer.
At this point we need to emphasize that you still only have 180 days total to complete a reverse exchange and get all the properties sold and transferred appropriately.
Can you go past the 180 days? The answer is, yes. However, if that is a circumstance that may possibly apply to your situation, it can get complicated. So, if you might need such a solution, it would behoove you to give us a phone call at 844-655-1031 so we can cover all the variables, including the costs.
Now let's cover a couple of pitfalls which are associated with reverse exchanges.
First, reverse exchanges don't have to be difficult, but because the logistics are much more exacting and complex, the potential for a serious problem always exists. That's why it's important that you plan your reverse exchange before you start.
Pitfall number one. How your Facilitator structures your reverse exchange is absolutely critical to having a successful transaction! Always verify that your Facilitator is experienced in handling reverse exchanges, and that they use a separate LLC to park the title to your property during the exchange period. If they don't use a separate LLC for your property, it creates unnecessary risk which is never worth it just to save a few hundred dollars in fees. It is bad practice, and way too risky for the Exchanger.
Pitfall number two. Make sure your Facilitator discloses all of the exchange costs and fees up front to avoid a costly surprise later. And remember that your reverse exchange fee is going to be substantially more than a standard deferred exchange because of the added LLC costs and closing logistics.
It's also important to understand how your Facilitator handles the logistics of getting the new property transferred into your name. Because if they aren't careful, they can actually create a double transfer tax when you receive title to your new property.
While these are two of the major pitfalls, there are many other elements to a reverse exchange that are equally important to understand, so give us a call and we'd be happy to walk you through the entire process.
