Reverse exchanges are useful, but they aren't for everyone.

We've all seen the situation where the taxpayer, attempting to accomplish a tax-deferred exchange, runs out of time, and, despite his good intentions, has to pay tax on the gain from the sale of his property held for investment or use in his trade of business. This is because the laws governing delayed tax-deferred exchanges, which permit only 45 days for identifying the possible "replacement" property and 180 days for closing escrow on acquiring one of those identified properties, have no grace period or available extensions. When the real estate market is as active as it has been lately, this can create problems. It also has given rise to some fraudulent tax-planning, and the penalties that come with it if one is caught. Isn't there a better way, a legal way, to deal with these time limitations?

There is, with the new paradigm called "reverse" exchanges, which provide a way for the taxpayer to have control over these time constraints. In addition, a variation on the strategy gives a taxpayer the ability to construct new or additional improvements, and have the value of those new improvements be included in the "cost" of the new, "replacement" property.

The parties in a "reverse" exchange are the same as in a regular, delayed, exchange, but with one addition: This new party has been called, by various tax-planners, the "Special Purpose Entity" ("SPE"), and other similar names to indicate that this party has a special, limited role to play.

A "reverse" exchange is called for when either the replacement property has to close, and be acquired from the current seller, before the relinquished property is sold or when the exchanger desires that certain improvements be made to the replacement property before he acquires it in the exchange transaction. Usually, either the seller will not agree to do them, or the exchanger doesn't want the seller to do them.

There are two basic themes to a "reverse" exchange. The most common is for the SPE to become the interim buyer of the replacement property, and hold it, under contract with the exchanger, until the exchanger is ready to sell the relinquished property to the qualified intermediary, or QI, who then sells it to the contract buyer. Meanwhile, at the same time the SPE transfers the replacement property to the QI. The QI then completes the exchange by transferring the replacement property to the exchanger. In some instances, where the Exchanger wants improvements to be constructed, the SPE also agrees to construct improvements on the replacement property before the exchange is completed.

There are, however, some transactions where, for reasons outside the control of the exchanger, a third party cannot own the replacement property, even temporarily, before it vests in the exchanger. One such circumstance is where there is a securitized loan that is going to be used to finance the acquisition. In those situations, the second theme is used: the SPE becomes the interim buyer for the relinquished property, thus allowing the exchanger to consummate the exchange before the "real" buyer of the relinquished property is able to close escrow.

Currently, there are certain risks in consummating a "reverse" exchange. The IRS has indicated that by the end of this year it probably will adopt some legislation that would give these transactions the protection of a "safe harbor" presumption of legality (as is already provided in the case of delayed exchanges using a QI). But until the IRS acts, it should only be used when there is no other option.

Although the IRS has not spelled out what the safe harbor will permit, it seems likely that it will follow, for the most part, the advice of the recommendations proposed by the Taxation Section of the American Bar Association. These recommendations provide a very liberal framework for structuring a "reverse" tax-deferred exchange. Although there is no assurance that the IRS will ultimately adopt these proposals, they do provide guidance to structuring these transactions even now (again, if that is one's only option to preserve tax-deferral). They also give some insight into what the ABA anticipates the IRS will do to provide for a more practical approach to consummating a tax-deferred exchange under Section 1031.

It should be noted, also, that until the IRS does adopt legislation that legitimizes these transactions, there is some risk that a "reverse" transaction will be disallowed if audited, and therefore the authors do not recommend this structure if another alternative structure (e.g., the "regular," delayed, exchange) is available. But if a "reverse" exchange is structured so as to closely hew to the anticipated IRS pronouncement, tax professionals believe that the taxpayer can take a good-faith reporting position that this is a valid exchange, and is not subject to any penalties.

Other issues which need to be addressed to ensure that the taxpayer is protected, not only in terms of reporting the transaction as a valid exchange, but also in protecting the taxpayer's investment include the following: First, the SPE should be a legal entity, not a person; it has to be properly organized and operate legitimately, and file tax returns. Also the SPE should not be a "disqualified" person (this is the same limitation as for a QI in a regular, delayed exchange). The SPE should be formed solely for one transaction, as the holding of multiple properties under one entity (for a number of different exchangers) can create non-tax liabilities, particularly resulting from environmental claims.

Second, the documentation between the SPE and the Exchanger must create binding, arm's-length obligations, and should fully describe and deal with all of the possible circumstances that could arise during the course of the relationship. In other words, it should describe each party's rights and responsibilities if improvements under construction are damaged or destroyed during the course of construction.

Third, all financing documents have to be completed (whether the person lending to the SPE is an institutional lender, or the exchanger), and delivered. Loans should be legitimate obligations (and so recorded on the SPE's accounting records), and should bear legal rates of interest, with interest being paid currently or accruing until the end of the transaction.

Fourth, the SPE must actually have a recorded vested interest in whichever property it acquires; this means that there will be a duplication of escrow fees, and transfer taxes, which is an additional expense that the exchanger will have to bear.

Is the "reverse" exchange for everyone? Until the IRS issues its ruling that legalizes the tax-deferral using the "reverse" exchange structure, it should not be used except in situations where it is not possible to structure a "delayed" exchange: In other words, it should be considered, for the time being, the "last resort."

Once the IRS issues its ruling, the use of the "reverse" exchange will add significant flexibility to planning an exchange transaction. For example, where the exchanger wants improvements to be built on the "replacement" property before the exchange is completed, or where the market conditions are such that the exchanger has to be absolutely certain that it will be able to acquire the intended "replacement" property, or even when the exchanger just doesn't want to take the risk that it won't be able to meet the 45-day and 180-day time limitations of a regular delayed exchange; in all these cases, there will be more flexibility.

Whether before or after the IRS pronouncement, the use of a "reverse" exchange can create many more planning opportunities; this new paradigm also creates new issues that must be addressed, as a new player, the SPE, plays an active, legitimate, and valuable role in facilitating these transactions.