With a Section 1031 Exchange, Can I Buy Another Investment Property First, and Then Exchange the One I Already Have for It?

Overview

A Reverse 1031 Exchange is the same as a Delayed 1031 Exchange, except that the Exchangor does things backwards.

He purchases the Replacement Property before he sells the Relinquished Property. That’s why it is called a Reverse 1031 Exchange.

The problem with a Reverse 1031 Exchange is that Section 1031 does not permit the Exchangor to own both properties at the same time, because he must use the Net Sales Proceeds from the Relinquished Property to purchase the Replacement Property.

So, the IRS has provided a way to do it in Revenue Procedure 2000-37.

You can read it on the IRS website at irs.gov. It was written by Peter Baumgarten, one of the better writers of Revenue Procedures at the IRS, and it is well worth reading.

Revenue Procedure 2000-37 requires the use of an entity called an Exchange Accommodation Titleholder (EAT) to hold either the Relinquished Property or the Replacement Property, using a written document called a Qualified Exchange Accommodation Arrangement (QEAA), between the Exchangor and the EAT.

What all of that means is that the Exchangor will sign an agreement with a QI that provides that the QI will set up a Limited Liability Company (LLC) specifically for the purpose of acting as the EAT for the Exchangor.

The QI will be the manager of the EAT and control it.

Then the Exchangor will sign a QEAA agreement with the EAT.

The QEAA will state that:

• The intent is to do a Section 1031 Exchange,
• The EAT is acquiring and holding the property solely for the benefit of the Exchangor in order to meet the requirements of Section 1031,
• The EAT will be considered the titleholder for income tax purposes, and
• The EAT will file the necessary tax returns and information reports.

The situation can be handled in one of two ways:

1. the EAT can purchase the Relinquished Property from the Exchangor and sell it to someone else, an arrangement we will call “Sell First,” because the Exchangor is selling 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 we will call “Buy First,” because the EAT is first buying the property for the Exchangor.

We will look at each, in turn.

Sell First

In this scenario, the Exchangor has found Replacement Property that he feels 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 he will need to reinvest in the Replacement Property, and he needs this information in order to determine his down payment and Note amount for the purchase of the Replacement Property, 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.

In analyzing this transaction, we will use use a hypothetical Taxpayer who is an investor in income properties. His name is Alan Adams, and he is selling a Duplex, and buying a Fourplex, or in this case, the reverse.

The first problem can be solved by transferring ownership of the Duplex, the Relinquished Property, to the EAT under the terms of the QEAA.

This is not considered a sale by Adams. He is just “parking” the Duplex out of his name.

Then Adams can purchase the Replacement Property immediately.

When the EAT takes title to the Duplex, the EAT will assume any existing debt on the property, and sign a Note back to Adams for the remaining amount of the sales price.

But the Note will not be payable to Adams. It will be payable to the QI so that the QI can hold the Net Sales Proceeds for Adams. Adams has already assigned his rights to receive the proceeds from the Sales Contract to the QI.

The first time period has started running. The EAT will have 180 days from the date that it receives the Relinquished Property to transfer the Relinquished Property to a Buyer, and Adams will be under the same 180-day time limit to close on his Replacement Property.

If Adams already has a contract to sell the property that the EAT just took title to, the Duplex, he transfers that contract to the EAT. If he does not already have a contract, he will be responsible for finding a Buyer.

When the EAT sells the property, the Note that the EAT assumed will be paid off by the Title Company out of the sales proceeds at closing, along with any other debts, and the EAT will instruct the Title Company to send the net funds to the QI.

If Adams has not yet closed on the Replacement Property, the QI will notify the Title Company handling that transaction that the funds are available.

If Adams has already closed on the purchase of the Replacement Property, the QI will send the funds to Adams, who will not be subject to taxation on the funds because he put the same amount of new money into the Replacement Property, and he will report this information to the IRS when he files his Form 8824.

Also remember, the EAT is just a “shell company.” It has no money, no office, no employees, and the QI is not willing to manage the property that the EAT just acquired, during the time period before the property can be sold.

So, the terms of the QEAA can provide that the EAT leases the Relinquished Property back to Adams so that he can continue managing it without interruption.

The second problem of not knowing the exact amount of Net Sales Proceeds can be overcome by just making a good estimate. All of the numbers are known except for the eventual sales price of the Relinquished Property that the EAT will sell, and Adams has projected a high, medium and low figure for that.

Adams just picks the highest of his estimated sales prices, estimates his Net Sales Proceeds, and he will still be safe if it is below that.

The third problem of not having the sales proceeds to purchase the Replacement Property will be discussed in the next section.

Buy First

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 his money from selling the Relinquished Property.

We will use Adams as an Example again.

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 EAT has 180 days in which to complete this.

The difficulty with the EAT purchasing the Replacement Property is that the EAT is an LLC that was set up by the QI and it is basically a paper entity. It has no assets, no business history, no credit history, and no money.

No lender will consider making a loan, and the QI will not be willing to borrow the money to buy the property. That is not their business model.

Adams might be able to find a lender willing to make the loan to the EAT and have the loan guaranteed by Adams; this is allowed under Rev. Proc. 2000-37, but the property that would be securing the loan, the Replacement Property, is owned by the LLC, not by Adams, and the QI owns the LLC.

The lender will probably not be comfortable with this, and if the lender is a chartered bank, it might even be against banking regulations.

But let’s assume that Adams is able to arrange a loan to the LLC and that loan will be secured by the property.

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 will have to 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, and the sale of the Relinquished Property has not taken place yet.

But we can estimate what this number will be.

If the Sales Price is $450,000 and $400,000 is allocated to the real estate, and the expenses of sale are $10,000 then the net will be $390,000. And the balance on the Note to be paid off is $18,000, so Adams will have available Net Sales Proceeds of $372,000.

This will have to be the amount of his down payment. He will have to loan this amount to the LLC and then arrange for the LLC to get a loan of $433,000 in order for the LLC, acting as the EAT, to purchase the Replacement Property for $805,000.

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

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 forms a legal entity called an LLC, and the QI is the sole member, owner, and manager. The LLC will act as the EAT.
3. The QI drafts a QEAA to be signed by Adams and the EAT.
4. 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.
5. Adams arranges with his bank to guarantee a loan to the EAT for $433,000 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.
6. Adams signs a contract with the owner of the property to purchase the Fourplex for $800,000 and makes the contract assignable.
7. Adams assigns the sales contract to the EAT.
8. The EAT grants Adams an exclusive option to purchase the Replacement Property for $805,000, using the Note owed to Adams by the EAT as an offsetting credit and agreeing to permit Adams to assume the bank loan.
9. 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 $433,000. The EAT also signs an Assignment of Rents to the bank.
10. The EAT leases the Replacement Property to Adams.
11. Adams begins to manage the Replacement Property and begins making payments to the bank on the Note, using the rents collected.
12. Adams identified 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.
13. Adams sells the Duplex as his Relinquished Property and the Title Company wires the funds to the QI.
14. The EAT transfers title to the Replacement Property to Adams in return for cancellation of the $372,000 Note and the assumption of the $433,000 loan.
15. 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.
16. The QI files the necessary reports and tax returns, and then dissolves the LLC.
17. Adams will report the 1031 Exchange on Form 8824 when he files his own tax return on the due date.

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 would 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 1031 Exchange, the IRS will consider this the same as receiving cash at the time of the sale, and the cash would be taxable as Boot.

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

Adams could have refinanced the property more than a year before the sale, 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 Exchange done in 90 days, he could 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 1031 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 government authority assesses a fee based on a percentage of the value of the property.

That means that when the EAT files his deed after purchasing the Replacement Property, he could be assessed a fee.

Then, shortly thereafter, when Adams files his deed from the EAT on the same property, he could be assessed a fee.

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, the LLC can be 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 the 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 probably 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 1031 Exchange.

But the decision is yours, and if you choose to go ahead, just make sure that you have a very good QI working with you. 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, and sometimes it is just necessary to do it this way for a variety of reasons.