Reverse 1031 Exchange: Considerations in Financing the Purchase of Replacement Property

In a hot market or market’s with limited inventory, the 45-day identification rules under a 1031 tax deferred exchange can feel like too small a window. (To read more about 1031 exchange process and rules, visit our 1031 explained page) Luckily, the 1031 exchange rules provide for the ‘Reverse Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange ’ to exist. Under the Treasury Regulations, exchanges must be completed in the proper sequence. This means the sale of the relinquished property must take place before the acquisition of the new or replacement property. However, on occasion, the facts are such that a taxpayer wishes to acquire the new property before the sale or risk losing the desired new property. This reverse sequence, also approved by the IRS, is often referred to as a “reverse 1031 exchange.” The reverse exchange technique essentially consists of an exchange accommodator holding or “parking” title to the new property on behalf of the taxpayer to avoid the taxpayer having simultaneous ownership of two properties. Immediately after the sale of the old property (but no later than 180 days) the exchange accommodator transfers the new property to the taxpayer. This 'technically' creates the proper sequence. Financing the Purchase of the Those certain items of real and/or personal property qualifying as “replacement property” within the meaning of Treasury Regulations Section 1.1031(k)‑1(a) and either: (a) received by the taxpayer within the designation period in accordance with Treasury Regulations Section 1.1031(k)‑1(c)(1) or (b) identified in a written designation notice signed by the taxpayer and hand delivered, mailed, telecopied or otherwise sent to the qualified intermediary before the end of the designation period in accordance with Treasury Regulations Sections 1.1031(k)‑1(b) and (c). The definition of “replacement property” shall not include property the identification of which has been revoked by the taxpayer in accordance with Treasury Regulations Section 1.1031(k)‑1(c)(6); (“New Asset”) Property or properties properly received by a taxpayer as part of a 1031 exchange. Replacement Property

The concept of a Reverse 1031 exchange can sound attractive to many investors until the reality of financing the purchase of the replacement property is considered.  For investors with the means to purchase the property outright in cash or those with strong lending relationships this can be relatively straightforward, however, for others they must ensure they take some nuances into consideration such as:

1. The title to the replacement property will be parked with an entity created by the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary for the sole purpose of holding title to the property.  The loan cannot be in the name of the taxpayer, but instead must be in the name of the parking entity.  This requires a short-term bridge loan that can be refinanced into a longer-term loan or paid down once the old property is sold and new property is transferred into the name of the taxpayer.  Many banks will not entertain these loans as they do not fit into their traditional lending model.  It may take some time discussing with several local or regional banks to get them to understand the structure. 
2. Ensure you have sufficient collateral and equity.  Banks will underwrite the replacement property as well as look at the taxpayers overall financial position to ensure adequate coverage.  Traditionally, banks are willing to lend between 65-75% of the replacement property’s value to qualified buyers depending on the type of property and quality of collateral.
3. Think about financing well in advance of pursuing a purchase through a reverse 1031 exchange.  Banks take time to order appraisals and underwrite collateral for specialty bridge financing.  This can be several weeks.  If you are in a rush and can’t wait for a bank, there are lenders willing to provide these types of loans, but you are going to pay handsomely for it in rate and upfront fees

Financing a reverse  exchange can be more difficult than a traditional loan, but it is common place for 1031s.  Take the time and do the research by speaking with several banks and the right Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary - Accruit.