* Intent is to do a Section 1031 Exchange,

* EAT is acquiring and holding the property solely for the benefit of the Exchangor in order to meet the requirements of Section 1031,

* EAT will be considered the titleholder for income tax purposes, and

* EAT will file the necessary tax returns and information reports with the IRS.

You will not have to do this yourself, your QI will do it for a fee.  But if you are interested, the Qualifications for an EAT are outlined in Treasury Regulation 1.1031(k)-1(k).

The Reverse 1031 Exchange can be handled in one of two ways:

1. The EAT can purchase the Relinquished Property from the Exchangor and sell it, an arrangement which we will call “Sell First,” or

2  The EAT can purchase the Replacement Property and hold it until the Exchangor has sold the Relinquished Property, and then sell the Replacement Property to the Exchangor, an arrangement that we call “Buy First.”

We will explain the procedure for each one.

SUMMARY: Whether the Exchangor chooses the “Buy First” or the “Sell First” he will have the same 3 problems with his Reverse 1031 Exchange:

1. He cannot hold title to both pieces of property at the same time.
2. He has not sold his Relinquished Property so he does not know the amount of net sales proceeds that he will have to invest in the Replacement Property, and therefore the amount of new financing.
3. He does not yet have the money to purchase the Replacement Property because he has not sold the Relinquished Property.

There are ways to deal with all three problems.

In addition, he can avoid the double payment of Title Policy fees and the double payment of Real Estate Transfer fees.

READING TIME: Approximately 15 minutes.

SELL FIRST IN REVERSE 1031 EXCHANGE

First, a quick word.

If you are one of the victims of the rampant misinformation on the web that says you cannot sell your investment property if you were thinking certain thoughts when you bought it (I know, bizarre!), get the facts here about Intent.

Now, back to the Reverse Exchange.

In this Reverse 1031 Exchange scenario, the Exchangor has found Replacement Property that he feels that he must purchase immediately.  He cannot wait until after he sells the Relinquished Property.

But he has three problems:

1.) He cannot hold title to both pieces of property at the same time, and

2.) He has not sold the Relinquished Property, so he does not know the amount of Net Sales Proceeds that he will have to reinvest in the Replacement Property, and he needs this information in order to determine how much his down payment will be, and he needs to know this in order to decide his note amount will be (whew!), and

3.) He does not yet have the money to purchase the Replacement Property because he has not received his money from the sale of the Relinquished Property.

We will use Alan Adams and his transaction as an Example in analyzing this Reverse 1031 Exchange. The facts are as follows:

:: Adams bought a Duplex ten years ago for $200,000 cash.

:: He assigned a value of $20,000 to the land, $180,000 to the building.

:: He began depreciating the building.

:: He spent $30,000 cash on two garages, began depreciating.

:: He spent $20,000 cash on furniture, began depreciating.

:: He has claimed $65,400 straight-line depreciation on the Duplex.

:: He has claimed $7,644 straight-line depreciation on the garages.

:: His total straight-line depreciation claimed is $73,044.

:: He has claimed $15,200 accelerated depreciation on the furniture.

:: His total overall depreciation claimed is $88,244.

:: His Basis in the property is $161,756 (200,000 plus 30,000 plus 20,000 minus 88,244).

:: Bob Baker has offered him $400,000 cash for the Duplex.

:: If he accepts, his Capital Gains will be $238,244 (400,000 Sales Price minus 161,756 depreciated basis.

:: $15,200 of the $238,244 will be Accelerated Depreciation Recapture, taxed at 39.6%, resulting in $6,019 taxes.

:: $73,044 of the $238,244 will be straight line Depreciation Recapture, taxed at 25%, resulting in $18,261 tax.

:: $150,000 of the $238,244 will be regular Capital Gains, taxed at 20%, resulting in $30,000 tax.

: His total tax liability will be $54,280 (6,019 plus 18,261 plus 30,000).

THE FIRST REVERSE 1031 EXCHANGE PROBLEM

The first problem that Adams has, that of not being able to hold title to both pieces of property at the same time, can be solved by transferring title to the Duplex, the property that will become his Relinquished Property, to the EAT.

Under the terms of the QEAA, this is not considered a sale by Adams, but he is considered to be just “parking” the Duplex out of his name.

So, for Reverse 1031 Exchange purposes, he no longer “owns” the property.

He can now proceed with the purchase of the Replacement Property.

It is critical that this procedure be done exactly right.

And it is critical that you understand that the IRS is holding you responsible for making sure that your Reverse 1031 Exchange is done exactly right.  If it isn’t, your Section 1031 Exchange will be disallowed and you will be writing a check to the IRS for $54,280.

It does not matter that you could show the IRS that your Qualified Intermediary is responsible for screwing up the transfer.

The Qualified Intermediary is not your agent and he is not providing you legal advice, he is an independent third party.

The agreement that you signed with him acknowledges all of that.

This is between you and the IRS.

When the EAT takes title to the Duplex, the EAT will:

• assume any existing debt on the property, and
• sign a note for the remaining amount of the sales price, creating a second lien on the property, and
• the note will be made payable to the QI, not the Exchangor.

The first time period for the Reverse 1031 Exchange has started running.

This is the Reverse 1031 Exchange Timeline.

The EAT will have 180 days to transfer the Relinquished Property to a buyer.

If Adams already has a contract to sell the Duplex, he transfers that contract to the EAT.

If he does not already have a contract, he will have to find a buyer for the EAT to sign a contract with.

When the EAT does eventually sell the property:

• the note that the EAT assumed will be paid off,
• other debts and closing costs will be paid,
• the remaining funds will be used to pay the note that the EAT signed with the QI,
• the QI will release the lien securing the second note, and
• the QI will send the funds to Adams.

Now, remember, the EAT is just a “shell company.”

It has no office, no employees, etc., and the QI is the only member, the sole owner, and the manager.

And the QI is not willing to manage the property that the EAT just acquired, during the period of time before the property can be sold.

So the QEAA can provide that the EAT leases the property back to Adams so that he can continue managing it without interruption.

This is a fairly common practice in a Reverse 1031 Exchange.

So, even though he “sells” the property to the EAT, he doesn’t give up possession and nothing else changes.

He continues with his management activities and his efforts to find a buyer.

The EAT does nothing.

THE SECOND REVERSE 1031 EXCHANGE PROBLEM

The second problem of not knowing the exact amount of net sales proceeds that he will need to invest in the Replacement Property can be overcome by just making a good estimate.

Adams already has a contract for $400,000 and he can estimate his net sales proceeds.

But even if he did not have a contract, he could just pick three prices: high, low, and average.  Then he could estimate his net sales proceeds based on these, because he knows all of the other numbers.

He would probably just pick the highest price and estimate the net sales proceeds based on that.  If it comes in lower, he has not broken any rules.

THE THIRD REVERSE 1031 EXCHANGE PROBLEM

The third problem of not having the use of the net sales proceeds to purchase the Replacement Property will be covered in the next “Buy First” scenario.

BUY FIRST IN REVERSE 1031 EXCHANGE

This is the same scenario.

The Exchangor has found Replacement Property that he wants to purchase immediately.  He cannot wait until after he sells the Relinquished Property, and he does not want to give up the Relinquished Property first.

He has the same three problems:

1.) He cannot hold title to both pieces of property at the same time.

2.) He does not know the amount of net sales proceeds he will need to reinvest, and

3.) He does not have the money to purchase the Replacement Property because he does not have the proceeds from selling the Relinquished Property.

We will use Adams as an Example again.

THE FIRST REVERSE 1031 EXCHANGE PROBLEM

The first problem of holding both pieces of property at the same time can be solved by use of the EAT.

Under the terms of the QEAA, the EAT will purchase the Replacement Property and hold it until Adams has sold the Relinquished Property.

Then the EAT will sell the Replacement Property to Adams.

The holding period requirement is 180 days.

The difficulty with the EAT purchasing the Replacement Property is that the EAT is an LLC set up by the QI, and it is basically a paper entity.

It has no assets, no business history, no credit, and no money.

No lender will consider making a loan.

And the QI is not willing to borrow the money to buy the property.  That is not his business model.

Adams might be able to find a lender willing to make a loan to the EAT and have the loan be guaranteed by Adams, but the property that is securing the loan will be owned by the LLC, not Adams, and the QI owns the LLC, and lenders are not very trusting of the people or companies that operate as Qualified Intermediaries.

But, so that we can continue with the Reverse 1031Exchange, let’s assume that Adams is able to arrange a loan to the LLC and that loan will be secured by the property and guaranteed by Adams.

Adams still has to come up with the down payment, which would probably be at least 20% in order to qualify for the loan, but in this case, would be much more.

Remember, in order to qualify for Section 1031 Exchange treatment, Adams must put into the Replacement Property all of the Net Sales Proceeds from the sale of the Relinquished Property, which has not yet been sold.

But we can estimate what this would be.  In fact, we already have.

If the sales price is $400,000 and the expenses of sale are $10,000 and the balance on the note of $18,000 is paid off, Adams will have net sales proceeds of $372,000.

This will be the amount of his down payment.

He will have to loan this amount to the EAT and then arrange for the EAT to get a loan for $333,000 in order for the LLC, acting as the EAT, to purchase the Replacement Property for $705,000.

This seems highly unlikely to happen, but let’s assume that it will, just so that we can see the mechanics of a Reverse 1031 Exchange.

1.)  Adams signs or amends his contract with his QI containing all of the terms of their agreement regarding what the QI will be doing and how he will be doing it.

2.)  The QI drafts a QEAA to be signed by the EAT and Adams.

3.)  Adams loans $372,000 to the EAT with the note secured by all of the assets of the LLC, and the note is Payable On Demand, and if no demand is made, in 180 days.

4.)  Adams arranges with his bank to guarantee a loan to the EAT for $333,000 to be secured by the Replacement Property, and to be assumable by Adams if he either acquires the Replacement Property or acquires 100% ownership of the LLC.

5.)  Adams signs a contract with the owner of the property to purchase the Fourplex for $705,000 and makes the contract assignable.

6.)  Adams assigns the sales contract to the EAT.

7.)  The EAT grants Adams an exclusive option to purchase the Replacement Property for $705,000 using the note owed to Adams by the EAT as an offsetting credit, and an agreement to permit Adams to assume the bank loan.

8.)  The EAT purchases the Replacement Property from Carl Carter, using the cash of $372,000 borrowed from Adams, and signing a note to the bank for $333,000.  The EAT also signs an Assignment of Rents to the bank.

9.)  The EAT leases the Replacement Property to Adams.

10.)  Adams begins to manage the Replacement Property and begins making payments to the bank on the note from the rents collected.

11.)  Adams identifies to his QI within 45 days three possible properties that he will sell as the Relinquished Property, one of them being, of course, the Duplex.

12.)  Adams sells the Duplex as his Relinquished Property and the Title Company wires the funds to the QI.

13.)  The EAT transfers title to the Replacement Property to Adams in return for cancellation of the $372,000 note and the assumption of the $333,000 bank note.

14.)  The QI transfers the net sales proceeds of $372,000 received from the sale of the Relinquished Property to Adams, replacing the $372,000 that Adams loaned to the LLC.

15.)  The QI files the necessary reports and tax returns, and then dissolves the LLC.

16.)  Adams will report the Reverse 1031 Exchange on his Form 8824 when he files his own tax return on April 15, 2018.

CONCLUSION

As you can see, the primary problem with doing a Reverse 1031 Exchange is the availability of money.

I have been asked why Adams wold not just borrow the $372,000 that he needs for the down payment from the bank and put a second lien on the Duplex, and then when he sold the Duplex, the note could be paid off.

That way, he would not have to use his own money.

The answer is that if the Relinquished Property is refinanced, and that’s what he would be doing, within one year before it is sold, and that refinancing is tied to the circumstances of the Reverse 1031 Exchange, the IRS will consider this the same as receiving cash at the time of the sale, and the cash would be taxable.

The refinancing would have the effect of reducing the amount of the “net sales proceeds” that Adams would be required to use to purchase the Replacement Property, and also have the effect of providing tax-free cash to Adams in the process.

The IRS considers this an attempt to circumvent the requirements of Section 1031.

To stay out of trouble with the IRS, you should read how to Refinance and how not to Refinance.

Adams could have refinanced the property more than a year before his Reverse 1031 Exchange, but since he did not know that he would be needing the money, he would probably not have done that.  Besides, there is a “lost opportunity” cost with just having money sitting in a bank earning no interest.

One technique that I have seen used by serious investors is to always have more than one investment property with significant equity.  It is not easy to get into this position, but once you do, the opportunities are tremendous.

While Adams could not borrow the $372,000 that he needed by refinancing the property that would become the Relinquished Property, he could have borrowed it against the equity that he has in a warehouse that he owns.

It would be a short-term loan, probably all due in six months, and probably would not cost him more than $12,000 in interest.

If he could manage to get the entire Reverse 1031 Exchange done in 90 days, he cold cut the cost to about $6,000,  That is a reasonable expense for the use of $372,000 for three months.  And it would allow him to do the deal.

Another observation that I would make about a Reverse Exchange involves the double payment of taxes.

Some states levy what is called a real estate transfer tax.

That means that when you file a deed transferring real estate to a new owner, the local taxing authority assesses a fee of anywhere from $1.00 per $1,000 of valuation up to $8.00 per $1,000 of valuation.

That means that when the EAT files his deed after purchasing the Replacement Property, he could be taxed $5,600.

Then, shortly thereafter, when Adams completes his Reverse 1031 Exchange and files his deed from the EAT on the same property, he could have to pay another $5,600.

The second fee could be avoided if, instead of the EAT deeding the property to Adams, the QI just transferred ownership of the LLC to Adams, since the LLC owns the property.

Now, immediately, if you have been paying attention, you recognize that this is a problem because the name of the buyer of the Replacement Property would not be the same as the seller of the Relinquished Property, as required by Section 1031.

But there is an anomaly in the law regarding LLCs that says that if the entity has only one member, that member can elect to have the LLC treated as what is called a “disregarded entity” and it is the same as the single member being the owner of the entity’s assets, including those assets actually titled in recorded instruments in the name of the entity.

So Adams can actually receive his ownership in the Replacement Property by becoming the single-member owner of the LLC that owns the Replacement Property, and this would avoid the second payment of a real estate transfer tax, if he were faced with that problem where he lives.

And finally, you should be aware that in the world of Title Insurance, the rule is that the purchaser of property receives a policy of title insurance that promises to reimburse him for any loss suffered by reason of a defect in title.

But the policy only insures him, it does not insure any subsequent owners.  If they want coverage, subsequent owners must purchase their own title policy.

So, the EAT would be insured, but Adams would not.

However, there is also a provision in all state insurance laws that provides that if a purchaser is only acting as an accommodation titleholder, the Title Company can add an Endorsement to the Title Insurance Policy that also insures the person for whom the title is temporarily being held, in this case, Adams.

But you have to ask for the endorsement ahead of time.

As you can tell, I don’t recommend that an individual attempt to do a Reverse 1031 Exchange.  It is much more complex and somewhat more expensive than a Delayed Like Kind Exchange.

But the decision is yours.  If you decide to go ahead, just make sure that you have a very good QI involved.  If you survive it, you will become a stronger investor.

Of course, property developers and investment companies should have no hesitation using this technique.  You probably have the manpower and financial resources to handle it, sometimes it is just necessary to do it this way for a variety of reasons.