In a reverse 1031 exchange, the replacement property is acquired prior to selling the relinquished property. This can provide a challenge for those loans on the old property with a due on sale clause. The reason is that in a reverse 1031 exchange, the Internal Revenue Service does not allow the taxpayer to own both the new and the old property at the same time. Consequently, either the old or new property must be titled to an Exchange Accommodator Titleholder, otherwise known as an EAT. The EAT must bear the burdens of ownership and be added to the property’s insurance policy should the parked property sustain damage from a hurricane, fire, flood or other catastrophe.
1031 Exchange
An Internal Revenue Code Section 1031 exchange allows a taxpayer to defer the federal and state capital gain and recaptured depreciation taxes for real or personal property when sold. The property must be held for productive use in trade, business or for investment and is exchanged solely for property of like kind to be held for productive use in trade or business or for investment. A 1031 exchange requires the engagement of a Qualified Intermediary (QI) to facilitate the exchange. QIs must be a third party, independent, and not related to the taxpayer. Disqualified parties are those who have acted on behalf of the taxpayer within two years prior to the exchange. Exceptions include parties who have provided banking, escrow or title closing services. Attorneys, CPAs, Realtors, employees and family members are disqualified from providing accommodation services should they or their firm be engaged to provide non-exchange related services.
Reverse Exchange Steps
Once the taxpayer elects to initiate a reverse 1031 exchange, the decision is made to park one or the other properties with the EAT in what is known as a reverse first or reverse last structure. Revenue Procedure 2000-37 was issued on September 15, 2000, and provides direction regarding the parking of properties.
Reverse First
From a lender’s perspective, a reverse first is the preferable structure because it allows the taxpayer to acquire the replacement property without the EAT being on title to the new property. From the taxpayer’s viewpoint, it can be a challenge because the equity to acquire remains in the relinquished or old property. Consequently, engaging a lender is necessary unless the taxpayer has access to equity personally or from family members, affiliated companies or in other real estate. While the EAT is on title to the relinquished property, insurance, taxes and operating expenses, including mortgage payments are the responsibility of the taxpayer.
Is it possible that a due on sale clause in the existing relinquished property mortgage could cause the lender to seek immediate loan satisfaction? Given mortgage payments continue to be paid on time, my experience as a QI is that the lender has not pursued calling their loan.
Reverse Last
In a reverse last, the replacement property is acquired with funds provided by the taxpayer while title is conveyed or parked with the EAT. The relinquished property continues to be titled with the taxpayer until sold. If not notified in advance, the lender may balk at the EAT or single member liability company being on title to the property. It is highly recommended to alert your lender in advance of the loan committee review to discuss provisions that would provide the assurance to overcome their potential objection. A non-recourse note signed by the EAT may suffice. The key is having this conversation in advance of the loan approval. Engage the QI to explain the process to the lender.
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