Taxpayers Should Contact a Tax Professional When it Comes to Financing Reverse Exchanges

Taxpayers engage in a wide variety of so-called "parking" transactions, to facilitate reverse 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 describes a safe harbor for reverse exchanges. Non safe harbor exchanges are effective if the QI has sufficient benefits and burdens of ownership, so that the QI will be treated as the owner for federal income tax purposes.

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 QI or arranges acquisition financing through a commercial lender. In either case, sufficient safeguards need to be in place to protect the taxpayer, lender and the QI. The structure of the financing depends on whether the parking arrangement falls under the safe harbor. The Rev Proc requires that title to the replacement property must be held by "a person" who is not the taxpayer or a disqualified person. This "person" is also known as an exchange accommodation titleholder (“EAT”), typically a single member LLC owned by a QI. Since the EAT will own the replacement property, taxpayers should be diligent in their choice of a QI.

Financing the Safe Harbor Exchange
A taxpayer with sufficient liquidity can simply lend the acquisition financing to the EAT. The loan can be interest free, and would be evidenced by promissory note and secured by a mortgage.

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 mortgage is deemed insufficient security (which is typically the case) the Rev. Proc. does allow the taxpayer 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, secured by a second mortgage.

Financing the Non Safe Harbor Exchange
The IRS acknowledges that parking arrangements can be accomplished outside the safe harbor. According to the Rev. Proc., 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 benefits from 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.

Due to the complexities involved, a taxpayer entering into a reverse exchange should contact a tax professional in structuring and implementing these types of transactions.