Legal Developers

Reverse Like-Kind/1031 Exchange (Part 2)

**See Part 1 – Like-Kind Exchanges

REVERSE, REVERSE.

A reverse like-kind exchange is just that, a like-kind exchange done in reverse. In a typical like-kind exchange, also known as a forward exchange, a property owner sells a property and uses the proceeds to buy a replacement property of like-kind within 180 days. This allows the property owner to defer paying capital gains tax on the sale of the original property (See Like-Kind/1031 Exchange Basics (Series Part 1)). However, in a reverse like-kind exchange, the order is reversed. The property owner first acquires a replacement property before selling their existing property.

A reverse like-kind exchange can be beneficial in situations where the property owner has identified a replacement property that they want to acquire before they can sell their existing property. In this type of exchange, the property owner has up to 180 days after acquisition of the replacement property to sell their existing property and complete the exchange. Additionally, the taxpayer can benefit from an appreciation of the existing property during the exchange period and the taxpayer can combine sales of currently owned investment properties to purchase a larger investment replacement property without being taxed on capital gains. The biggest difference between a reverse like-kind exchange and a like-kind exchange is that the taxpayer must be able to fund the purchase of the replacement property because they have not yet received the proceeds from the sale of the existing property (i.e. the property they are selling).

Reverse like-kind exchanges can be complex because the taxpayer cannot hold title to the replacement property while the existing property is being sold. Instead, an Exchange Accommodation Titleholder (EAT), also known as a Qualified Intermediary (QI), is used to facilitate the exchange process. The EAT is a neutral third party that acts as a middleman and holds title to the replacement property and ensures that the taxpayer meets all of the IRS requirements.

IMPROVEMENTS

There are additional complications if the taxpayer wants to improve the replacement property as part of the exchange because the taxpayer technically does not own the property during the exchange period. However, there are ways to structure the exchange to allow for improvement.  One option is for the taxpayer to use a “build-to-suit” exchange. In this type of exchange, the taxpayer identifies a replacement property that needs improvement, then enters into a long-term lease agreement with an intermediary, who holds title to the property and makes the necessary improvements. Once the improvements are complete, the taxpayer can then purchase the property from the intermediary as part of the reverse exchange.

TIPS

Because of the complexity of reverse like-kind exchanges, it is often beneficial to form an LLC or other limited liability entity to execute the exchange.[1] An LLC is advantageous because LLCs provide liability protection, flexibility, pass-through taxation, and ease of transfer for a taxpayer engaging in a reverse like-kind exchange. The LLC will then coordinate with the EAT or QI and enter into the necessary agreements. During the exchange period, the LLC can lease the property back to the taxpayer so the taxpayer can claim all income and expenses from subleasing the property if they wish (and no improvements are being done). If the taxpayer decides to form an LLC, don’t forget to have the LLC and its members added as additional insureds on any title policy.

Finally, be wary of transfer taxes. If the reverse like-kind exchange is not executed within the exchange period and strictly followed, the taxpayer could be subject to tax on capital gains. The rules and requirements for reverse exchanges can be more stringent than those for forward exchanges, so it is important to consult with a tax professional and a qualified intermediary to ensure compliance with the regulations.

[1] The taxpayer can be the sole member of the LLC and lend money to the LLC to execute the transaction

The information contained in this publication should not be construed as legal advice, is not a substitute for legal counsel, and should not be relied on as such. For legal advice or answers to specific questions, please contact one of our attorneys.