A reverse exchange could be your solution in this current real estate market

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The One problem that comes up in almost every conversation I have with clients right now is how hard it is to find a replacement property. There’s very little inventory, and worthwhile properties get scooped up immediately. As a result, many of my clients are afraid to pull the trigger on their sale. A reverse exchange could be their solution in this dilemma.

Just as its name implies, a reverse exchange allows you to take advantage of the tax benefits of a 1031 exchange, but instead allows you to purchase your new property before you sell your old one. In a reverse exchange, your qualified intermediary takes title to the new property and holds it until you close the sale of your old property. This allows you to tie down the purchase of your new property before you pull the trigger on the sale of the old.

One of the first things your intermediary will do is to establish a separate entity to handle your reverse exchange. This entity is called an “Exchange Accommodation Titleholder (or “EAT”) by the IRS and is usually structured as an LLC.

Most people must obtain financing for the purchase of the new property—and this is the big roadblock with reverse exchanges right now. To finance the purchase of the property, your lender will make the loan to the EAT (which you don’t own), secured by the new property (which will be held by the EAT), and the loan will be guaranteed by you. This type of loan is still outside the box for most lenders right now, although we’re starting to see clients with good relationships at community level banks obtain reverse exchange financing. Most of the reverse exchange financing we’re seeing right now is from a loan on other property owned by our client, or seller financing via an ownercarry loan provided by the seller.

You can expect that a bank lender is going to want a security interest in both the old and the new properties. This is their way of keeping you committed to completing the exchange, but this usually works to your benefit  because the lender will take the equity and loan values of  both properties into consideration when they analyze the loan. This may very well allow you to obtain a larger loan than you’d be able to get if just the new property was used as security.

Once you’ve sold your old property, the proceeds from the sale will go to your intermediary who will then set up a closing to transfer, or “flip,” the new property to you and complete your exchange. The sale proceeds are then used to first pay back the equity that you put up. If there are funds remaining, they will typically go to pay down the bank loan since any funds that go to you in excess of the money that you put up will be taxable. The existing bank loan will then be transferred to you along with the title to the new property. This will complete your exchange.
The IRS rules provide for two basic types of reverse exchanges. 

This is the bank’s way of keeping you committed to completing the exchange, but this usually works to your benefit . . .

The first, and most common type, is called a “safe harbor” reverse exchange. IRS rules lay out the structuring and documentation requirements for the reverse exchange. This provides that if the requirements are followed—the reverse exchange is completed within 180 calendar days from the date that your intermediary closes the purchase of the property—the IRS will not disallow it. Hence the name, safe harbor.

The second type of reverse exchange is typically called a “nonsafe harbor” reverse exchange. The structuring and documentation are different and there is no requirement that the exchange be completed within 180 days. However, you have no assurance that the IRS will not disallow your exchange if you go the nonsafe harbor route; although, at the time of this writing, there have not been any IRS rulings or court cases that have disallowed one of them. Because of the lack of guidance from the courts or the IRS on nonsafe harbor reverses, many intermediaries will not do them. So if you expect that your exchange might exceed 180 days and you want to go the nonsafe harbor route, you’ll have to scout around for an intermediary that does them. My company, of course, does both types.

Two last points in conclusion: first, you have to commit on the front end to going the safe vs. the nonsafe route for your reverse exchange. The documentation and structure is different between the two. And no: you cannot start out as a safe and then switch to a nonsafe. And lastly, reverse exchanges of either type are very complex, very expensive and best left to larger properties.

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