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Q. Can I do a "reverse exchange" and acquire my replacement
property before I sell the property I own?
A. Yes, but it can be a little complicated.
The problem comes up when you want to exchange a property you own (the
"relinquished property") for one you would like to acquire (the
"replacement property"), but you need to settle on the replacement
property before you can sell your relinquished property. Perhaps you have found
a great deal on a replacement property, but have not yet found a buyer for the
relinquished property.
For many years, reverse exchanges were done by having a "straw man"
acquire the replacement property for you and hold it until you could sell the
relinquished property. You then structured the sale of the relinquished property
as an exchange, and acquired the replacement property in the exchange. If the
transaction was structured properly, and the straw man took title to the
replacement property without being specifically obligated to convey it to the
taxpayer, these exchanges were generally considered to be safe.
The problem was that this meant you often couldn't borrow money to use to
acquire the replacement property. You needed to have all cash, and loan it to
the straw man, unless you could convince a lender to loan you money secured by
property owned by someone else.
But this used to be the only way to do a reverse exchange safely, and it was
not an uncommon practice. There was risk, however, both for the taxpayer (for
example, if the straw man decided not to let the taxpayer have the replacement
property) and the straw man (for example, if there was an environmental problem
with the property). There was also the risk that the IRS might challenge the
transaction.
In September of 2000 the IRS issued a revenue procedure (Rev. Proc. 2000-37)
specifically authorizing reverse exchanges. Basically, you still need a straw
man, or "accommodation titleholder." The straw man can either take
title to the replacement property (just like they used to before Rev. Proc.
2000-37) or the straw man can take title to the relinquished property while the
taxpayer acquires the replacement property. The 45 day and 180 day rules which
apply to normal exchanges now also apply to reverse exchanges. The taxpayer must
identify the replacement property within 45 days, and must complete the
transaction within 180 days.
If this is done correctly, it is a "safe harbor", meaning that the
IRS agrees that the transaction qualifies for exchange treatment.
The new procedure has at least three advantages:
- The straw man can hold the relinquished property, rather than taking title
to the replacement property, which will often make financing much easier.
- The straw man can be bound by a written agreement to convey the
replacement property to the taxpayer.
- The transaction can be structured as a safe harbor.
The disadvantage is that the 180 day rule may make it difficult for some
taxpayers.
The old procedure, which was never approved by the IRS should still be
available. Following the old procedure means that the taxpayer loses the benefit
of the safe harbor and other advantages of Rev. Proc. 2000-37, but should still
be able to have an exchange which does not meet the 180 day rule. It is
important to decide, in advance, whether to proceed under the new, or the old
procedure.
A good attorney or accountant should always be consulted before attempting an
exchange. This is especially important before attempting a reverse exchange.
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