The duplex close to the university campus was too good for Harvey Blanks to pass up.
An acquaintance of mine for more two decades and a longtime real estate investor, Blanks had been in a holding pattern for the past 18 months, waiting for more positive signs in home sales. However, he signed an agreement on Jan. 4 to purchase the duplex, believing the deal was a huge bargain.
"It’s not just about the built-in rental pool that will always be there because of the university," Blanks said, "but the building’s in great shape and the seller needed to get out of it. The timing isn’t great for me, but it’s a great long-term play."
The timing wasn’t great for Blanks because he had intended to sell another one of his properties via a tax-deferred exchange in order to purchase the duplex. Taxpayers can defer capital gains tax by selling one investment property and then buying another investment property of equal or greater value within certain time frames.
However, Blanks can still get his tax-deferred deal done by taking an extra step. The tax-deferred exchange process can be reversed if the title to the "new" property (in this case, the duplex) is held by an independent third party (typically a facilitator or attorney) until the "old" property sale closes. The old property in this case is another one of Blanks’ properties he had listed for sale but had yet to sell.
Section 1031 of the tax code specifically requires that an exchange take place. That means that one property must be exchanged for another property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax-deferred transaction from a sale and purchase. The exchange is created by using an intermediary (or exchange facilitator) and the required exchange documentation.
Since the reverse exchange takes an extra step to accomplish, the process can be more expensive than the typical Section 1031, or Starker, exchange. The reverse procedure, however, provides the same "safe harbor" protection for reverse exchanges that delayed exchanges enjoy.
Revenue Procedure 2000-37, which allows the reverse exchange, was added to the tax code mainly because investors were losing tax-deferred status at the last minute for circumstances beyond their control.
For example, a buyer who has filled out all the proper exchange forms and adhered to the proper time frames is scheduled to close the sale of one property on Tuesday and roll the funds into the purchase of another property on Thursday. On Monday, he learns that the buyer of his "old" property must delay the purchase for a couple of weeks because the buyer’s lender needs additional information before it will fund the loan.
The seller of the "new" property understands the problem and agrees to extend escrow on the "new" property. (Sometimes, sellers demand that the deal close as the two parties agreed, or the seller will sell the property to someone else and keep the earnest money.)
In this situation, the buyer’s best alternative is to do a reverse exchange and have a qualified intermediary (or exchange facilitator) take title to the new property and hold, or "park" it until the old property closes. Then, the intermediary transfers the new property to the seller to complete the exchange. These "parking" arrangements are the main ingredients of the reverse exchange procedure.
The original Section 1031 will not let a taxpayer buy the replacement property, or new property, until after he or she has sold the old, or relinquished, property. Typically, a replacement property must be identified within 45 days of the sale of the "old" property. And, the sale of the replacement property must close within 180 days of the sale of the "old" property.
One of the challenges with the reverse exchange has been extra cash. If the buyer does not have the extra cash elsewhere to buy the replacement property, will lenders finance the property with the facilitator holding title?
Sometimes lenders have extended funds for a specific period of time to the facilitator as long as the loan is secured by the person making the exchange. And, as mentioned, sellers have been known to extend the closing period on replacement properties.
If you are attempting a reverse exchange, it’s best to hire a professional third party to handle the process. An exchange specialist has been there before and knows what the IRS wants to see.