INTRODUCTION TO REVERSE EXCHANGES

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1 INTRODUCTION TO REVERSE EXCHANGES By Lee David Medinets, Esq. Certified Exchange Specialist Senior Counsel, Madison Exchange, LLC The purpose of this memo is to give introductory, generic information on reverse exchanges made pursuant to IRC It is not intended to give transaction-specific advice. I am generally available to discuss or to correspond with clients, their legal advisors and their tax advisors concerning the details of any particular transaction. IRC 1031 permits the tax-deferred exchange of like-kind property that is held by the taxpayer for productive use in trade or business or for investment. This statute is an exception to the general rule that taxes accrue as soon as property is transferred at a profit. Therefore, the statute is strictly construed, and compliance must be technically and formally correct. Nevertheless, the IRS has explicitly and repeatedly stated that 1031 exchanges are normal tax planning tools, and they are not given special scrutiny if they appear to be conducted in a proper fashion. IRS practice appears to confirm those statements. In a normal forward exchange, relinquished property is sold through a qualified intermediary (a QI ). The exchange proceeds from sale of the relinquished property are held by the QI, and they are used in whole or in part to acquire replacement property designated by the taxpayer. In a reverse exchange, the taxpayer wants to acquire replacement property before the relinquished property can be sold. This would not be possible to do using a normal forward exchange because owning both the relinquished property and the replacement property at the same time is inconsistent with an exchange.

2 The solution is to hold title to either the replacement property or to the relinquished property in the name of an exchange accommodation titleholder, or EAT during the period between the time the replacement property is acquired and the time that the relinquished property is sold. Prior to 2000, this was a delicate procedure because the EAT needed to have sufficient incidents of ownership in order for the taxpayer to satisfy the IRS that the EAT was the owner of the parked property during the exchange period. However, the procedure has been streamlined by IRS Revenue Procedure which created a safe-harbor procedure for parking arrangements, a term that includes both construction exchanges and reverse exchanges. 1 Under 1 Relevant Excerpt from Rev. Proc : SECTION 4. QUALIFIED EXCHANGE ACCOMMODATION ARRANGEMENTS.01 Generally. The Service will not challenge the qualification of property as either replacement property or relinquished property (as defined in (k)-1(a)) for purposes of 1031 and the regulations thereunder, or the treatment of the exchange accommodation titleholder as the beneficial owner of such property for federal income tax purposes, if the property is held in a QEAA..02 Qualified Exchange Accommodation Arrangements. For purposes of this revenue procedure, property is held in a QEAA if all of the following requirements are met: (1) Qualified indicia of ownership of the property is held by a person (the exchange accommodation titleholder ) who is not the taxpayer or a disqualified person and either such person is subject to federal income tax or, if such person is treated as a partnership or S corporation for federal income tax purposes, more than 90 percent of its interests or stock are owned by partners or shareholders who are subject to federal income tax. Such qualified indicia of ownership must be held by the exchange accommodation titleholder at all times from the date of acquisition by the exchange accommodation titleholder until the property is transferred as described in section 4.02(5) of this revenue procedure. For this purpose, qualified indicia of ownership means legal title to the property, other indicia of ownership of the property that are treated as beneficial ownership of the property under applicable principles of commercial law (e.g., a contract for deed), or interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes (e.g., a single member limited liability company) and that holds either legal title to the property or such other indicia of ownership; (2) At the time the qualified indicia of ownership of the property is transferred to the exchange accommodation titleholder, it is the taxpayer's bona fide intent that the property held by the exchange accommodation titleholder represent either replacement property or relinquished property in an exchange that is intended to qualify for nonrecognition of gain (in whole or in part) or loss under 1031;

3 (3) No later than five business days after the transfer of qualified indicia of ownership of the property to the exchange accommodation titleholder, the taxpayer and the exchange accommodation titleholder enter into a written agreement (the qualified exchange accommodation agreement ) that provides that the exchange accommodation titleholder is holding the property for the benefit of the taxpayer in order to facilitate an exchange under 1031 and this revenue procedure and that the taxpayer and the exchange accommodation titleholder agree to report the acquisition, holding, and disposition of the property as provided in this revenue procedure. The agreement must specify that the exchange accommodation titleholder will be treated as the beneficial owner of the property for all federal income tax purposes. Both parties must report the federal income tax attributes of the property on their federal income tax returns in a manner consistent with this agreement; (4) No later than 45 days after the transfer of qualified indicia of ownership of the replacement property to the exchange accommodation titleholder, the relinquished property is properly identified. Identification must be made in a manner consistent with the principles described in (k)-1(c). For purposes of this section, the taxpayer may properly identify alternative and multiple properties, as described in (k)- 1(c)(4); (5) No later than 180 days after the transfer of qualified indicia of ownership of the property to the exchange accommodation titleholder, (a) the property is transferred (either directly or indirectly through a qualified intermediary (as defined in (k)-1(g)(4))) to the taxpayer as replacement property; or (b) the property is transferred to a person who is not the taxpayer or a disqualified person as relinquished property; and (6) The combined time period that the relinquished property and the replacement property are held in a QEAA does not exceed 180 days..03 Permissible Agreements. Property will not fail to be treated as being held in a QEAA as a result of any one or more of the following legal or contractual arrangements, regardless of whether such arrangements contain terms that typically would result from arm's length bargaining between unrelated parties with respect to such arrangements: (1) An exchange accommodation titleholder that satisfies the requirements of the qualified intermediary safe harbor set forth in (k)-1(g)(4) may enter into an exchange agreement with the taxpayer to serve as the qualified intermediary in a simultaneous or deferred exchange of the property under 1031; (2) The taxpayer or a disqualified person guarantees some or all of the obligations of the exchange accommodation titleholder, including secured or unsecured debt incurred to acquire the property, or indemnifies the exchange accommodation titleholder against costs and expenses; (3) The taxpayer or a disqualified person loans or advances funds to the exchange accommodation titleholder or guarantees a loan or advance to the exchange accommodation titleholder;

4 this procedure, in addition to an exchange agreement, there is a qualified exchange accommodation agreement between the taxpayer and the EAT. That agreement allows the taxpayer to make improvements and to manage and operate the parked property during the exchange period which may last for a maximum of 180 days. At the end of the exchange period, the property must be transferred by the EAT to the taxpayer. My company, Madison Exchange, LLC, has a wholly owned subsidiary named Madison to Park, LLC., often referred to as MTP. The sole activity of MTP is to act as the EAT in these parking arrangements. In order to avoid commingling various properties and in order to reduce real estate transfer taxes, mortgage expenses and closing costs, we generally perform Reverse Exchanges by having the EAT hold the replacement property in the following manner: A new, single purpose limited liability company is formed in the state where the property is located. This type of entity is usually referred to as a single purpose entity or SPE. On large (4) The property is leased by the exchange accommodation titleholder to the taxpayer or a disqualified person; (5) The taxpayer or a disqualified person manages the property, supervises improvement of the property, acts as a contractor, or otherwise provides services to the exchange accommodation titleholder with respect to the property; (6) The taxpayer and the exchange accommodation titleholder enter into agreements or arrangements relating to the purchase or sale of the property, including puts and calls at fixed or formula prices, effective for a period not in excess of 185 days from the date the property is acquired by the exchange accommodation titleholder; and (7) The taxpayer and the exchange accommodation titleholder enter into agreements or arrangements providing that any variation in the value of a relinquished property from the estimated value on the date of the exchange accommodation titleholder's receipt of the property be taken into account upon the exchange accommodation titleholder's disposition of the relinquished property through the taxpayer's advance of funds to, or receipt of funds from, the exchange accommodation titleholder..04 Permissible Treatment. Property will not fail to be treated as being held in a QEAA merely because the accounting, regulatory, or state, local, or foreign tax treatment of the arrangement between the taxpayer and the exchange accommodation titleholder is different from the treatment required by section 4.02(3) of this revenue procedure.

5 transactions, it is quite common to include bankruptcy remote provisions in the company s certificate of formation or in its operating agreement. However, this is not as common on transactions smaller than about $5MM. The sole member of this SPE is Madison to Park. The sole managers of the SPE are myself and Esther Silberberg, our Director of Operations. The SPE takes title to the replacement property. It can sign all normal mortgage documents, including a note that would create personal liability against the SPE. It will not, however, sign mortgage documents that create liability against Madison to Park, Madison Exchange, their principals, employees or agents. Generally, banks require personal guarantees of mortgage documents by principals of LLCs that borrow money. In this case, those guarantees would be signed by the taxpayer who will eventually own the property. During the exchange period, the taxpayer can use, operate and freely manage the property, collect rents and pay bills. When the first of the following contingencies occurs, the replacement property is transferred by Madison to Park to the taxpayer: (a) when the relinquished property is sold; (b) when 180 days have passed from the start of the exchange; or (c) when the taxpayer s tax return is due (including all extensions that were granted) for the year when the exchange began. Transfer of the replacement property from the EAT to the taxpayer is most easily accomplished by transferring ownership of the SPE from Madison to Park to the taxpayer. This works because ownership of a single member LLC is considered by the IRS to be equivalent to ownership of the assets that are owned by the LLC. As the IRS terms it, a single member LLC is a disregarded entity (unless it has expressly elected to be treated as a corporation). Transferring the property by transferring ownership of the SPE does not disturb the title insurance on the property. It does not disturb the mortgage on the property, providing that the mortgage documents permitted this transfer. It does not require the recording of any documents. It does not require a formal closing. In most states there is no real estate transfer tax on this type of transfer, either. For these reasons, this is the preferred method for completing the exchange. It is, of course, also possible to transfer ownership of the replacement property by a deed from the SPE to the taxpayer.

6 In order for the transfer of the SPE to the taxpayer to work for 1031 exchange purposes, it is necessary that each taxpayer receive his or her own SPE company, so that each company remains a disregarded single member company after the transfer, and not an LLC taxed as a partnership. Therefore, there must be one SPE for each tenant in common who owned the relinquished property. If the relinquished property was owned by a partnership or corporation, that partnership or corporation is treated as a single taxpayer. Therefore, a single SPE owning the replacement property can be transferred to the partnership or corporation. It is possible to perform a reverse exchange where the EAT holds the relinquished property instead of the replacement property, and this is an appropriate technique to use in certain cases. However, the preferred technique is for the EAT to hold the replacement property for several important reasons, including but not limited to the following: 1) In states with real estate transfer tax laws like New Jersey s, having the EAT hold the replacement property in the name of an SPE that is eventually transferred to the exchanger usually saves an additional and avoidable real estate transfer tax. New York and certain other states do not tax transfers of real estate from the exchanger to the EAT or from the EAT to the exchanger regardless of whether this is done by deed or by transferring the company that owns the real estate. 2) Most owners of business and investment real estate prefer to hold real estate in separate SPEs in order to limit liability exposure. Many commercial lenders insist on that practice. By having the EAT hold the replacement property, it is possible to avoid setting up an SPE for the relinquished property that would be useful only during the exchange period and that would later have to be wound down. 3) Transferring the relinquished property to the EAT causes a technical default in the exchanger s mortgage. This is not a very big problem if the exchange is completed. However, it is a serious problem if the exchange fails and the property has to be returned to the exchanger with a mortgage that is now in default.

7 4) Transferring the relinquished property to the EAT voids the title insurance policy that covered the relinquished property. 5) Having the EAT hold the replacement property, rather than the relinquished property, often avoids the need for an extra Phase I or Phase II environmental inspection on the relinquished property. 6) If the exchanger makes improvements in the replacement property during the exchange period, the cost of those improvements can be taken as a credit against the proceeds from the eventual sale of the relinquished property. The difficulty in having an EAT hold the replacement property usually has to do with the reluctance of some mortgage lenders to accommodate this type of transaction. That reluctance has become increasingly rare since Rev. Proc was issued. Rev. Proc has made reverse exchanges much more common. As a result, lenders have become familiar with them and have learned how to handle them. Residential home lenders still have some problems with this type of transaction because they charge more for loans to limited liability companies than they do for loans to individuals. However, accommodation can often be made even with this type of loan. If no accommodation is possible, then the exchanger should elect to have the EAT hold the relinquished property rather than the replacement property, despite the disadvantages. When Madison performs a reverse exchange where the relinquished property is held, the procedure is almost a mirror image of a reverse exchange where the replacement property is held except that the transfer of the relinquished property from the EAT to a third-party purchaser cannot usually be accomplished by transferring the SPE that owns the real estate. Instead, the third-party buyer almost always requires a deed which results in additional taxes and expenses. In all reverse exchanges, there is the problem that the proceeds from the sale of the relinquished property will not be available toward acquisition of the replacement property at the time that the replacement property is being purchased. Therefore, the exchanger needs to have a bridge loan

8 or other financial resources that would not be necessary in a forward exchange. This problem is unavoidable as are the additional costs associated with a reverse exchange. I hope that this description is clear enough and useful for your purposes. Please feel free to contact me with questions about this or any other 1031 exchange matter. Tax-Related Disclaimer: Any federal tax advice contained in this communication was not intended or written by the author to be used, and it cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Any tax advice contained in this communication may be held by the Treasury or the IRS to have been written to support, as that term is used in Treasury Department Circular 230, the promotion or marketing of the transactions or matters addressed by such advice because the author has reason to believe that it may be used or referred to by another person in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to one or more taxpayers. Before using any tax advice contained in this outline, a taxpayer should seek advice, based on the taxpayer s particular circumstances, from an independent tax advisor. END

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