Legal Topics

By Don B. Hancock Hancock & McGill
Attorneys at law

Reverse Exchanges Under the New IRS Safe Harbor

Real estate investors now have a new weapon in the never-ending battle to reduce or eliminate taxes levied upon the sale of real estate. In 2000, the IRS published Revenue Procedure 200017, which creates a safe harbor for certain types of reverse exchanges.

What is a Reverse Exchange?

For those of you who are not familiar with tax-deferred exchanges, a little background information is probably required. A safe harbor, in IRS terminology, is a set of rules promulgated by the IRS which if followed, guarantee that the transaction will not be challenged by the IRS.

Since 1991, we have had safe harbor rules for "normal" or "forward" exchanges, defined here as an exchange in which the taxpayer sells her relinquished property before she acquires the replacement property.

A reverse exchange occurs when a taxpayer has to acquire replacement property before disposing of relinquished property. We now have safe harbor rules for reverse exchanges. Taxpayers have been doing reverse exchanges all along; however, the lack of safe harbor rules meant there was substantially more risk that the IRS would challenge a reverse exchange. With the safe harbor rules, that risk has been eliminated if a taxpayer follows the safe harbor rules.

Who might benefit from a reverse exchange?

Some common examples of people who would benefit from a reverse exchange include a property owner who is forced to close on the purchase of a property under contract when his relinquished property does not sell as quickly as he had hoped. Often a property owner will need or want to start construction on a replacement property before selling the relinquished property so that the replacement property will he ready to occupy when the relinquished property is sold. Or a choice property might come on the market unexpectedly and have to be purchased quickly before relinquished property can be marketed or sold.

Now, when a reverse exchange is beneficial, a. taxpayer can choose to enter into the exchange with assurance that the exchange will meet IRS requirements if the exchange can be structured within the safe harbor rules. This means that many more taxpayers will consider a reverse exchange because of the reduction in risk.

Structure of a Reverse Exchange

A typical reverse exchange is structured as follows. The exchange accommodator (intermediary) creates an entity, typically a limited liability company owned by the accommodator, to hold title or "park" real estate. The exchange can be established to have the entity formed by the accommodator acquire and hold title to the replacement property until the taxpayer is ready to acquire the property at which time the exchange is completed by the taxpayer selling the relinquished property and acquiring the replacement property from the accommodating entity. A second structuring method requires the taxpayer to acquire the replacement property and simultaneously transfer the relinquished property to the accommodating entity. The accommodating entity then holds title to or "parks" the relinquished property until it can he sold when it is transferred to the ultimate purchaser.

The safe harbor rules permit substantial non-arms length dealing between the accommodator and the taxpayer. For instance, the taxpayer can loan the funds to the accommodating entity to acquire the property or may guarantee a loan from a third party lender. The parked property can be leased to the taxpayer and the taxpayer is permitted to manage the parked property, supervise the construction of any improvements or act as contractor for construction of improvements. These provisions mean that the taxpayer has defacto control over the property, even though title is held by a third party entity owned by the accommodator.

Agents and brokers should remain aware of the possibility of structuring reverse exchanges if the need arises and be ready to suggest to sellers that they seek legal and accounting advice abbot pursuing a reverse exchange if it is advantageous.

Don R. Hancock is a partner in Hancock & McGill, attorneys at law. Mr. Hancock is certified by the Texas Board of Legal Specialization as having special competence in residential and commercial real estate transactions. His received his undergraduate degree from Texas A &M University and his J.D. degree from the University of Texas School of Law.

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Always consult your tax attorney or tax advisor for additional information concerning your specific tax situation. If you are interested in initiating a Reverse Exchange, please contact us at tip_info@TexasIncomeProperty.com