The Reverse Exchange -- A Useful Tool

In a market this hot, if you want to do a 1031 exchange you have quite a dilemma. You would like to exchange your highly appreciated Old Property, but finding replacement property in time is difficult. In a straight 1031 exchange, you have 45 days from the date of sale to identify potential replacement property and 180 days to close the purchase. There are no extensions to these time frames! Property not identified or purchased in time will toast your exchange, and you'll pay tax on the sale of your Old Property.

We're currently in a market where inventory is in short supply, and if you don't act fast, properties are gone. If you're hesitant to sell your Old Property first for fear of not being able to find the perfect New Property in time, consider doing a "Reverse Exchange."

A Reverse Exchange arises when you want (or need) to buy your New Property before you've sold your Old. The problem is that the IRS will not let you be in title to both your Old Property and the New Property at the same time. To resolve this, the IRS issued a ruling (Rev. Procedure 2000-37) which, in simple terms, requires that your Qualified Intermediary (QI) take title to the New Property for you and hold, or "park" it until you get your Old Property sold. Once your Old Property closes, the QI transfers title to you and the exchange is completed.

Armed with this new tool, you're ready to surge forward, right? Not too fast, there are two hurdles to get through.

The first is financing. When the QI takes title to the New Property, they usually do so using a Limited Liability Company (an LLC).

The lender's loan, then, is to the LLC, secured by your New Property, and guaranteed by you. This makes the loan un-salable until you are finally in title to the New Property.

If you are working with a lender, ask them if they plan to sell your loan. If the answer is yes, they will not be able to finance your reverse exchange. You need a lender who will hold, or what they term "portfolio," the loan. Typically this will be a bank rather than a mortgage broker.

Your QI should be experienced enough to direct you to a good portfolio lender. Our experience is that portfolio lenders will not gouge you; their fees and rates are reasonable -- but you won't be able to negotiate a deal like you usually can with a mortgage company. Another benefit of dealing with a portfolio lender is that it is not uncommon for our clients to finance most, if not all, of the purchase of the New Property. If both properties are located in the same state, the lender will often take a security interest in both of them. Adding the value of both, and subtracting the debt, often yields enough room for a 100% loan for the purchase of the New Property.

Make sure the loan does not have a "due on sale" clause. If it does, you need to have the lender modify it so the loan is not called when ownership is transferred from the QI to you. Also, if you plan on leaving the loan in place after you take title from the QI, make sure there is a "re-amortization" clause. This will allow you to modify the payment when the loan is paid down after the sale of the Old Property.

The second hurdle in a Reverse Exchange is the fee to the QI. The QI has to set up an LLC to take title to the New Property and dissolve it when the exchange is completed.

They also need to keep a set of "books" for it and file tax returns.

In addition, there should be a whole set of legal documents over and above the straight or forward exchange that need to be prepared. Don't forget: they own the property -- not you! Therefore, an experienced QI should give you the comfort level you need to make sure the New Property is safe while in their control, and when they eventually transfer title to you.

Fees to the QI to do a reverse will not seem that bad if your transaction is large, say $500,000 or more. The smaller your transaction, the more prohibitive the cost will seem. Bear in mind it's the savings on the capital gains tax you're after, so get with your CPA to figure that out prior to committing to a reverse exchange.

Utilizing the reverse exchange has many benefits. In a market where property is moving as fast as it is in Florida, it's a great way to secure the New Property. In addition, buying the New Property first locks in the price now as opposed to taking the chance the cost will rise. This strategy also enables you to not "fire sale" the Old Property, and you can take more time selling your Old Property and get the right price. This may help offset some of the extra cost to the QI.