In my last post, we looked at how a safe harbor reverse exchange works under Rev. Proc. 2000-37. Either the relinquished property or the replacement property is “parked” with an “exchange accommodation titleholder” or “EAT”. We also discussed the restrictions on a safe harbor reverse exchange that must be included in a “qualified exchange accommodation agreement” (a “QEAA”) in order to have the benefit of the safe harbor. In this post we will examine the difference between parking a replacement property versus parking a relinquished property.
There are usually some significant advantages to parking the replacement property instead of the relinquished property:
(i) It is usually possible to secure the cooperation of the new mortgage lender for the replacement property to agree to carve out an exception from the “due on sale clause” which will allow for the transfer of the replacement property from the EAT to the taxpayer at the end of the exchange. On the other hand, transferring the relinquished property from the EAT to the taxpayer ordinarily would trigger the “due on sale” clause for any existing mortgage on that property. That is somewhat risky, especially if the relinquished property is not sold when expected. In the alternative, if the taxpayer wants to park a relinquished property, the taxpayer can seek prior approval of the current mortgage lender to permit transfer. That is usually even riskier than not asking at all because the lender might say “No,” or might charge a substantial fee for reviewing the loan and giving its approval.
(ii) If the replacement property is parked, the taxpayer has 45 days to choose which relinquished property will later be sold. When relinquished property is parked, there is no longer any choice.
(iii) When the replacement property is parked, the actual exchange of properties does not technically happen until the relinquished property is sold. When the relinquished property is parked, the exchange technically occurs as soon as the replacement property is acquired. If the relinquished property is sold for more than what the replacement property cost, then the clock starts running sooner than necessary on the time that the taxpayer has to acquire other replacement property in a forward exchange.
(iv) When replacement property is being purchased, it is common for the taxpayer to have in hand or to have ordered already due diligence information, particularly a Phase I environmental report, that the EAT will want to review prior to taking title. More often than not, the taxpayer cannot provide current due diligence information on relinquished property.
(v) Closing costs and transfer taxes can sometimes be reduced or eliminated when beneficial ownership of real estate is transferred by transferring ownership of a single purpose entity (“SPE”) that holds title to the property, rather than by transferring a deed to the property itself. It is relatively easy to arrange for the eventual transfer of the replacement from the EAT to the taxpayer by transferring ownership of an EAT. However, there are often serious obstacles to arranging for such a transfer when relinquished property is parked.
Despite these advantages, sometimes the structure for an exchange will not work if the replacement property is parked. In those cases, it is good to keep in mind the option of parking the relinquished property, and it is often necessary to deal with the drawbacks of that strategy.
There is a problem in forward exchanges that often crops up. The taxpayer would like to acquire replacement property that is owned by a related party. However, IRC § 1031(f) puts some severe restrictions on that practice – a discussion for another time. These restrictions, do not apply to the purchase of relinquished property by a related party. Therefore, in a reverse exchange, when the purchase of the relinquished property falls through, it is often possible to arrange for the relinquished property to be purchased by a related party, sometimes in a transaction involving substantial take-back financing from the taxpayer. This strategy is referred to as a “related party to the rescue” transaction.
Parking arrangements can be used for another purpose. The taxpayer may want credit for improvements made to the replacement property in addition to credit for purchasing the replacement property. This is referred to as a “construction exchange,” and it will be the principal subject of the next post.