Coming and Going: Take Advantage of the Current Real Estate Market with a Part Forward and Part Reverse 1031 Exchange

Section 1031 appears to many taxpayers and their professionals to be a very restrictive provision of the Internal Revenue Code. However, once you fully understand the law, the regulations, the court cases, and the various IRS rulings and pronouncements, you quickly realize that many planning opportunities exist, beyond the basic and most obvious. Often, these planning opportunities result from combining different rules.

One very valuable and frequently overlooked technique is to combine a forward exchange with a reverse exchange. The option may present itself when a taxpayer wants to sell multiple relinquished properties and trade up to a more expensive replacement property. However, the timing is often such that only one of the relinquished properties can be sold before having to purchase the replacement property. For example, in the current market, it is taking some sellers longer than usual to find buyers. At the same time, the seller may have had their eye on a suitable replacement property that has been listed for sale. Perhaps that property was just reduced to the perfect asking price and buyers need to act quickly. In these cases, the part-forward, part-reverse exchange may be the perfect solution.

In understanding how the part-forward, part-reverse exchange works, the 1031 rules must be analyzed. The 1031 rules are clear that an exchanger can sell a single property and acquire multiple properties. Conversely, an exchanger can sell multiple properties and acquire a single property. The key is to match values and debt. The rules are also clear that, if structured properly, an exchanger can effectively complete a reverse exchange whereby the exchanger, through an Exchange Accommodation Titleholder (EAT), acquires the replacement property prior to selling the relinquished property. The last rule of importance allows exchangers to swap a fee simple interest for a fractional interest in a property or to swap a fractional interest for a fee simple interest in a property.

The result of combining the rules is to allow the exchanger who desires to sell two relinquished properties and acquire a single replacement property, to sell one relinquished property, followed by the acquisition of the replacement property, followed by the sale of the other relinquished property. If done properly, with all the i's dotted and t's crossed, the exchanger can avoid all gain recognition entirely.

The essence of the part-forward, part-reverse exchange is that the exchanger sells the first relinquished property as a forward 1031 exchange following the normal procedures for a forward exchange. The net sales proceeds are sent to the Qualified Intermediary (QI) to be escrowed as exchange proceeds. Ideally, the exchange funds are held in a separately segregated, dual signatory totally liquid bank account.

Within the 180 day replacement period, the exchanger uses the exchange funds to acquire a partial interest in the replacement property. The remaining interest in the replacement property is acquired by the EAT. This remaining interest in the replacement property is acquired as in any reverse exchange with all or a portion of the purchase price coming from the exchanger, as a loan to the EAT, and any remaining portion coming in the form of a loan from an unrelated lender.

The next step is for the exchanger to sell the remaining relinquished property within 180 days of the EAT acquiring the replacement property. Upon such sale, the net sales proceeds are transmitted to the QI, then to the EAT and the interest in the replacement property is then transferred to the exchanger in completion of the reverse exchange portion of the transaction.

While this transaction may seem overly involved or confusing, in the hands of an experienced tax attorney, CPA or Certified Exchange Specialist® (CES®), the transaction should be completed without any risk of audit or adjustment. Furthermore, other variations are possible, involving, for example, more properties or construction or improvements to the replacement property.

The key to this or any 1031 exchange transaction is proper planning, in advance. In the transaction described above, the values of the various properties must be determined with relative accuracy. The amount of the debt on the relinquished properties must be analyzed and compared with the amount of debt that will be needed to acquire and, if desired, improve the replacement property. Timing is also a critical issue because the 180-day replacement periods as well as the 45-day identification periods all still apply.

Another factor is the cost involved. The fees charged by the QI and the EAT for a part forward, part reverse exchange will certainly be higher than a simple forward deferred exchange. Additional legal or accounting fees may be involved. More time may be spent by the lawyers explaining the transaction to the lender and dealing with title issues. However, when all is said and done, if the tax savings outweigh the costs, then a part-forward, part-reverse exchange just might be the perfect answer.

If you think that a part-forward, part-reverse exchange may be a possibility, seek competent tax and legal advice at the earliest stage possible. Moore McLaughlin, Esq., CPA, CES®, and Alexandra Hart of All States 1031 are always available for a complimentary consultation. Call All States 1031 toll free at (877) 395-1031 or visit AllStates1031.com for more information.