It’s Important for Tax Professionals to Understand that there are Several Types of Exchanges Available to Your Clients
Exchanging can range anywhere from a simultaneous exchange of two properties to a complex, multi-leg, multi-party transaction involving construction and/or reverse exchanges. It’s important for tax professionals to become familiar with the various types of exchanges. They are simultaneous, delayed, improvement and reverse exchanges.
The Simultaneous Exchange
In this transaction, the closing of the Exchange Property and the Replacement Property take place on the same day - there is no interval of time between closings. Prior to the 1979 Starker decision, most exchanges were limited to the simultaneous format. Since 1991, the only “safe harbor” for a simultaneous exchange is when using a Qualified Intermediary.
The Delayed Exchange
In this type of exchange, the Replacement Property is closed on a date later than the closing of the Relinquished Property. Often referred to as a “Starker Exchange,” after the well-known 9th District Court case in which the court ruled in the taxpayer’s favor for a delayed exchange prior to current IRS rules and regulations. The current IRS code dictates strict time frames for completion of a delayed exchange - 45 days to identify and 180 days to complete the exchange.
The Improvement or Construction Exchange (Title-Holding Exchange)
This exchange takes place when a taxpayer wants to acquire a property and arrange for construction of improvements on the land before it is received as Replacement Property. Typically, improvements are a building on an unimproved lot, but may include enhancements made to an already-improved property so as to create adequate value to close on the Exchange.
Note: Federal law does not permit a taxpayer to construct improvements on a property as part of a §1031 Exchange after the buyer has taken title to the property as Replacement Property in an exchange. In other words, the Intermediary needs to close on, take title and hold title to the property until the improvements are constructed, and then relinquish title of the Improved Property to the taxpayer as Replacement Property.
Improvement Exchanges are done in the context of both Delayed Exchanges and Reverse Exchanges, depending on the circumstances.
The Reverse Exchange (Title-Holding Exchange)
Revenue Procedure 2000-37 published by the Internal Revenue Service September 15, 2000, provided for the first time a safe harbor for taxpayers wishing to utilize the reverse exchange format.
In a Reverse Exchange, the Replacement Property closes before the client’s Relinquished Property. The Exchange Accommodation Title holder can take title to the Replacement Property or the Relinquished Property depending upon what the replacement property lender will allow.
Depending upon resources of the Exchangor and financing available, there are two variations of reverse exchanges:
1). Reverse “A” (Buy – Hold Replacement Property and exchange for Relinquished Property when it sells)
2). Reverse “B” (Buy Replacement Property –Exchange for Relinquished Property – Hold until it sells)
1) Reasons Why your client would do a Reverse Exchange
The purchase of Replacement property, (Phase II), for some reason must occur prior to the sale (Phase I) of the Relinquished property.
When timing problems exist because the purchase must close before the Relinquished property or transaction is impossible.
Frequently used in combination with another form of exchange such as a Reverse/Improvement exchange.
For example, a client may need to do a Reverse Exchange if the Buyer of their Relinquished Property just fell out of Escrow. All of the sudden your client does not want to lose out to another buyer on the property that they want to purchase so they would need to do a Reverse Exchange.
2) Structuring the Reverse Type ‘A’ exchange – (Exchange Last)
- Used when the replacement property is purchased for cash or the seller is providing financing or if the lender will allow the QI on title.
- The Qualified Intermediary (QI), as an Accommodation Title holder (AT), buys the replacement property with a loan from the exchangor or seller financing, (Phase I). The AT retains ownership for up to 180 days until a buyer for the relinquished property is found. Once the relinquished property is sold, the proceeds from the sale are used to acquire the replacement property from the AT and the exchange is complete (Phase II).
3) Structuring the Reverse Type B Exchange - (Exchange First)
- Used when the AT cannot go on title to the replacement property.
- The Exchangor loans the AT funds equal to their equity in the Relinquished Property. The AT then buys the Relinquished property in a regular Qualified Intermediary exchange. The QI then acquires the replacement property with funds from the sale of the Relinquished Property to the AT and immediately transfers title to the Exchangor and the exchange is complete. When the relinquished property (held by the AT) is sold the proceeds are used to repay loan from the Exchangor.
- A Reverse “B” allows the Exchangor to take title to the replacement property immediately.
4) Reverse/Improvement Exchange
- Provides ability to acquire and construct/improve property before disposing of Relinquished Property
- Combines structuring and timing features of reverse and improvement exchanges
- Solves problems of exchangors who must remain in existing facilities until new property is available
Multi-Property and Multi-Party Exchanges
An investor can trade out of one property into several or consolidate from smaller properties into one larger property. In addition, when you have two or more investors owning a property together they can trade into separate properties.
Personal Property Exchanges
Investment personal property is exchangeable for similar use personal property. The government has 13 general asset classes. Property belonging in one general asset class can be exchanged for another in the same general asset class (i.e. an aircraft can be exchanged for an aircraft or cows for other cows).
Additionally, the government has assigned North American Industry Classification System (NAICS) codes for property. Property in a NAICS code can be exchanged for property in the same NAICS code.