FEATURE ARTICLE, OCTOBER 2008

REVERSE EXCHANGE TRANSACTION FINANCING
Securing money for reverse exchange transactions requires attention to details, patience.
Derrick M. Tharpe, J.D.

Several years have now passed since the IRS published Revenue Procedure 2000-37, which created a safe harbor for reverse exchange transactions under §1031. In a reverse exchange transaction, the taxpayer generally has a need to acquire the replacement property prior to the disposition of the current relinquished property. The safe harbor provided by Rev. Proc. 2000-37 allows taxpayers to park designated replacement or relinquished property with a third-party exchange accommodation titleholder (EAT) for a period of up to 180 days prior to the sale or disposition of the relinquished property. Since the adoption of the revenue procedure, there has been an increase in the number of reverse exchange transactions, and the IRS has subsequently issued favorable rulings on the use and terms of the safe harbor. However, one of the elements of reverse exchange transactions which continue to generate issues for taxpayers and their advisors is the financing of these transactions.

It is critical that the taxpayer understand that he or she will need to provide the financing necessary for the exchange accommodation titleholders’ acquisition of the property. In a reverse exchange transaction, the financing is necessary because the taxpayer has not yet sold the relinquished property, so no exchange funds are currently available.

Generally, there are several potential sources of financing. Specifically, the safe harbor procedure states that the taxpayer or related party may loan monies directly to the EAT to include the cost of the replacement property and costs and expenses. In these circumstances, the loan can be secured by the replacement property. Additionally, the taxpayer or a related party may guarantee a loan from a third-party lender, and that loan may also be secured by the replacement property. Practical considerations regarding each of these financing options are set forth below.

Taxpayer Financing

Under Rev. Proc. 2000-37, the taxpayer can loan proceeds directly to the EAT for the acquisition of the replacement property. These funds may be available to the taxpayer through existing cash or an unsecured line of credit. This represents the easiest form of financing for a reverse exchange, provided the taxpayer has the means to follow this structure.

As a direct loan from the taxpayer to the EAT, the EAT will provide a promissory note to the taxpayer. The loan is then secured by the replacement property or, if the EAT has established a limited liability company, the membership interest in the LLC may be pledged. It should also be noted, that the safe harbor does not require the loan to contain arm’s-length provisions, according to Rev. Proc. 2000-37, §4.03. Therefore, the loan from the taxpayer to the EAT does not have to be an interest-bearing loan. Under this structure, the taxpayer would not want to earn interest income on the loan because there is no offsetting deduction, and the interest income would be subject to tax.

Third-Party Financing

In transactions where the taxpayer obtains a loan on behalf of the EAT from a third-party lender, the loan can be made directly from the third-party lender to the EAT with the taxpayer or a related party providing a guarantee. In many circumstances, where the EAT has established a LLC to hold the property, the membership interest in the LLC can be assigned to the taxpayer at the conclusion of the exchange. The transfer of the interest in the LLC may qualify as a transfer of the asset held by the EAT for purposes of §1031. Therefore, the existing loan to the LLC may remain in place, and there will be no need for an assumption or additional mortgage taxes paid on the transfer. In limited circumstances, the transfer of the LLC interest may have other tax consequences depending on the state or jurisdiction of the transaction.

As an alternative, the loan by the third party can be made to taxpayer, and the taxpayer can then subsequently loan those funds to the EAT. However, the taxpayer must be cautious in utilizing this structure because the lender will often want a security interest in the replacement property held by the EAT. This will often create a situation in which there is a subordination of the replacement property to the loan which the third-party lender has made to the taxpayer. As a result, the proceeds from the sale of the relinquished property may be utilized to acquire replacement property that is subject to a pledge of the taxpayer, which potentially could violate the G-6 restrictions of §1031.

Another issue may arise if the taxpayer attempts to borrow the funds for the EAT’s acquisition of the replacement property utilizing a third-party loan secured by the taxpayer’s relinquished property. Under such circumstances, the third-party lender will likely require a lien on the relinquished property as collateral for the loan. However, under §1031 principles, any debt taken on in anticipation of an exchange should have independent economic substance and should not be incurred for purposes related to the exchange. In a reverse exchange structure, the debt on the relinquished property would be incurred to finance the acquisition of the replacement property within the same exchange, therefore creating a significant issue for the §1031 transaction.

Conclusion

Through the adoption of Rev. Proc. 2000-37, the IRS simplified the process of accomplishing a reverse exchange transaction from a tax perspective. However, the underlying elements of the transaction, such as financing, require a great deal of care and attention to fundamental details in order to satisfy the requirements of a successful §1031 exchange.

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