Financing A Reverse Exchange

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October 14, 2005
Author: , Esq., CPA

Beginning with the birth of deferred like-kind exchanges, taxpayers have engaged in a wide variety of so-called "parking" transactions, to facilitate reverse exchanges and construction exchanges. Such transactions "warehouse" the desired replacement property with an independent party, such as a qualified intermediary ("QI"), until the taxpayer arranges for the sale of the relinquished property.

Revenue Procedure 2000-37 provides a safe harbor for reverse exchanges provided certain minimum requirements are met. One requirement is that the taxpayer cannot own the parked property during the exchange. Instead, title is taken by an exchange accommodation titleholder ("EAT"), which is typically a newly formed single member LLC owned by the QI.  Taxpayers failing to satisfy the safe harbor can structure the transaction to give the QI sufficient benefits and burdens of ownership, so that the QI will be treated as the owner for federal income tax purposes (a so-called "non safe-harbor reverse").

The biggest hurdle facing a taxpayer in a reverse exchange is how to provide the equity to purchase the property. The taxpayer either loans the money to the EAT or arranges acquisition financing through a commercial lender. In either case, sufficient safeguards need to be in place to protect the taxpayer, the QI and the commercial lender. Furthermore, the structure of the financing depends on whether the parking arrangement falls under the safe harbor.

1. Safe Harbor Exchange. 

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If the taxpayer has sufficient liquidity, the easiest solution is for the taxpayer to loan the acquisition financing to the EAT. Under the Rev. Proc., the loan can be interest free, and would be evidenced by promissory note issued to the taxpayer by the EAT. The loan would be secured by a mortgage, which may or may not be recorded by the taxpayer depending on the cost of recording the same.

If a commercial lender is involved, the requirement that the property be titled in the name of the EAT frequently causes consternation since the lender will have dealt with the taxpayer in arranging financing, only to discover that an unrelated EAT will be taking title to the property. Adding to the consternation is the fact that the EAT will insist on nonrecourse financing. If a recorded mortgage on the replacement property is not enough for the lender (which is typically the case), the Rev. Proc. does allow the taxpayer or a disqualified person to guaranty the obligations of the EAT. Furthermore, for the most conservative lenders, the guaranty can be secured by a mortgage on the relinquished property. Finally, the down payment for the purchase can be loaned by the taxpayer to the EAT and secured by a second mortgage (which the taxpayer may or may not opt to record).

2. Non Safe Harbor Exchange. 

In the Rev. Proc., the IRS acknowledges that parking arrangements can be accomplished outside the safe harbor. According to the Rev. Proc., "[d]etermining the owner of property for federal income tax purposes requires an analysis of all of the facts and circumstances. As a general rule, the party that bears the economic burdens and benefits of ownership will be considered the owner of property for federal income tax purposes."

The key to a successful non-safe harbor reverse exchange will remain careful structuring to meet the benefits and burdens test. The typical method of financing such an exchange is for the QI to apply for and obtain funding from an institutional lender with the equity portion loaned by the taxpayer to the QI. Both loans should be secured by mortgages on the property, and both should bear a market rate of interest. If possible, the taxpayer should avoid having to guaranty the loan. These transactions vary considerably subject to the willingness of the lender and the QI to accommodate the taxpayer, but the more the taxpayer bears the economic burden of the loan, the weaker the argument that the arrangement was entered into independently.

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