1031 Reverse Exchange

[Mike B.]

Hey BP: I'm a little foggy on the step by step process of performing a 1031 reverse exchange, and I'd appreciate some feedback. Here's my situation: My sister and I will be joint-venturing to purchase a commercial MF building this year. I need to sell a SFH that I own to help fund this deal, and for which I have a sizable gain. I don't like the idea of doing a forward exchange whereby I sell the SFH and then have a 45/180 day timeframe to close on the replacement property. To me this provides an incentive to buy an average deal just to fulfill the terms of the 1031. As such I'd like to pursue a reverse exchange, but have some questions about the overall process as well as the difference between a replacement property parked reverse exchange and a relinquished property parked reverse exchange.

What I'm having trouble with is how, in the relinquished property parked reverse exchange, things happen generally.  Here are some questions:

1. At what point do I relinquish title of the SFH to the EAT? After an AO on the MFH? At the closing table?

2. How does the EAT/Exhanger/QI apply the funds of the eventual sale of the SFH to the already purchased MFH?

Do you have an opinion as to whether or not one is generally more favorable/cost effective than the other?

[Bill Exeter]

Hi @Mike B., 

Reverse 1031 Exchanges do take most of the risk out of completing a 1031 Exchange, especially in today's market with tight inventory, multiple offers, bidding wars, COVID-19, etc.  They are more complicated and have additional costs.  

The first issue that needs to be addressed is how to you pay for the new replacement property since your equity is "trapped" in your relinquished property.  The answer to this question generally drives the decision on which Reverse 1031 Exchange structure to use (replacement property parking or relinquished property parking method). 

The best way to visualize a Reverse 1031 Exchange is two component steps/parts.  There is a "parking arrangement" where an Exchange Accommodation Titleholder (part of the Qualified Intermediary operation) will acquire and hold or "park" legal title to either the replacement property or relinquished property, and there is a concurrent/simultaneous 1031 Exchange.  The simultaneous 1031 Exchange occurs either at the beginning (front end) or back end of the Reverse 1031 Exchange.  

The preferred Reverse 1031 Exchange structure from the investors point of view (for many reasons) is what we call the Exchange Last structure where the only thing that occurs up front is the parking arrangement.  Legal title to the replacement property is acquired and held or "parked" by the Exchange Accommodation Titleholder.  The actual 1031 Exchange has not even occurred yet.  The actual concurrent 1031 Exchange occurs on the same day that the sale of your relinquished property closes (Exchange Last).  The day that you close and transfer legal title to your relinquished property to the buyer, the Exchange Accommodation Titleholder transfers the parked replacement property to you (concurrent 1031 Exchange).  

The investor would advance/loan funds to the Exchange Accommodation Titleholder ("EAT") or arrange for a lender to lend funds to the EAT to acquire the parked property.  The EAT signs a promissory note either to the investor, lender or other party that provided the funds.  The sale proceeds from the sale of the relinquished property are first received by the Qualified Intermediary.  The Qualified Intermediary then uses the funds to "acquire" the replacement property from the EAT.  The EAT then uses the funds to repay or pay down the loan. 

The Exchange First structure is used when the Exchange Last structure is not an option.  This involves a concurrent 1031 Exchange at the front end.  The investor acquires and receives legal title to his or her new replacement property at close, and transfers his or her relinquished property to the EAT concurrently with the close of the replacement property.  The EAT then holds legal title to the relinquished property until it sells.  This structure can also be used when the EAT is unwilling to park legal title to the replacement property for various reasons such as environmental contamination concerns.  

The primary reason the Exchange Last is the preferred structure is that the 1031 Exchange does not occur upfront so it does not matter (1) how you finance the acquisition of the replacement property; or (2) how much cash you put down on the property.