REVERSE EXCHANGES

A reverse exchange is a transaction in which the taxpayer acquires replacement property before selling the relinquished property. This is often done in cold markets where a replacement property at a good price can be acquired but the relinquished property is slow to sell. It also occurs in hot markets where a favorable price on a good replacement property is possible, but the relinquished property has not been sold. Occasionally the relinquished property has been sold, the taxpayer contracts for replacement property, the buyer of the relinquished property cancels the purchase, and the taxpayer cannot extend closing on the replacement property.

The Internal Revenue Service has authorized reverse exchanges in Rev. Proc. 2000-37. The Revenue Procedure is a safe harbor, providing detailed allowable structures and limitations for structuring reverse exchanges. So long as the safe harbor is followed, the Revenue Procedure provides that the IRS will not challenge the qualification of property as either replacement property or relinquished property, nor treat the accommodator which facilitates the reverse exchange as the agent of the taxpayer.

A reverse exchange is structured as a “parking” arrangement. The replacement property is acquired in a single-member limited liability company of which an exchange accommodator is the sole member. That structure is desirable in a jurisdiction like Hawaii with a conveyance tax because the Rev. Proc. permits assignment of the membership interest in the LLC to the taxpayer rather than the property which avoids the conveyance tax (in some jurisdictions such as assignment would require payment of the transfer tax but not in Hawaii – yet!).

The funds for acquisition must be loaned to the LLC (since the taxpayer does not yet have exchange funds from sale of the relinquished property) by the taxpayer which is the most challenging aspect of a reverse exchange. There are multiple methods of financing the purchase including:

• Mortgaging the relinquished property if equity is available.
• Using proceeds of a home equity line of credit (although after the Tax Cuts and Jobs Act of 2017 interest on the home equity line would not be deductible).
• Mortgaging the replacement property. Not all lenders are willing to fund reverse exchange loans although at least 2 or 3 banks in Honolulu will do so.

The accommodating LLC will give the taxpayer a promissory note and mortgage of the replacement property to secure the loan. When the relinquished property is sold the taxpayer, buyer and accommodating LLC enter into forward exchange documents providing for exchange of the relinquished property for the replacement property. The relinquished property exchange funds are used to pay off the note given by the accommodating LLC so the funds are paid to the taxpayer who can pay off any outstanding loans, or if the replacement property was mortgaged to finance the acquisition, that loan will be paid off.

Prior to the Rev. Proc. taxpayers were structuring reverse exchanges as parking arrangements, typically by contracting with an exchange accommodator to hold title to the replacement property. The Service did not challenges the transactions. Often the replacement property was held by the accommodator for considerable periods of time. The Rev. Proc. includes time limits. The time limits are similar to the time limits for deferred exchanges. The relinquished property must be identified within 45 days of the date the replacement property is parked with the accommodating LLC. That is usually done in the accommodation agreement with the accommodating LLC but if the taxpayer is uncertain of which property is to be sold, she can either identify within the 45 days or identify three properties (following the 3 property/200%/95% rules of identification). The relinquished property must be sold within 180 days of the date the replacement property is parked. If it is not, it can still be exchanged but not for the parked replacement property.

Reverse exchanges are more expensive that forward deferred exchanges. Accommodators continue to charge higher prices for accommodating the reverse exchange. This originated when they were required to hold legal title which posed considerable risk or environmental liability or casualties. Now that title is held in a limited liability company the accommodator as member is shielded from liability. Attorneys who prepare the documents charge more because of having to prepare two separate exchanges – the parking arrangement and the forward exchange when the relinquished property sold.