The Laurex Process: Exit Strategy Implementation
1031 Tax-Deferred Exchanges
By Greg Lehrmann

Real estate investing is similar to playing Monopoly. Winning at either takes savvy and the skill to negotiate the exchange of less desirable properties for more valuable ones. Texas property owners intent on winning should understand the many benefits of Internal Revenue Code section 1031 tax-deferred exchanges.

Tax-deferred exchanges have been in the tax code since 1921 and are among the significant tax advantages for real estate investors. The key advantage of a 1031 exchange is that it allows an investor to dispose of a property without incurring a capital gain tax liability. This allows the earning power of the deferred taxes to work for the benefit of the investor instead of the government.

Creative Exchange Strategies

As tax code rules and cases have evolved overwhelmingly in favor of taxpayers - especially with regard to real estate - exchanges have become easier. A seller hires a 1031 qualified intermediary (QI) to document the sale of a property as an exchange. The QI holds the proceeds to prevent the seller from being in a taxable situation. Potential replacement property is identified within 45 days after closing, and some or all of those properties are acquired within 180 total days after the sale. For real estate exchanges, the properties just need to be used in the exchanger's business or held as an investment. This format is called the delayed exchange.

Although the delayed exchange variation is the most common, many exchangers employ more creative strategies, such as reverse exchanges. A 1031 reverse exchange is called for when the replacement property must be acquired before closing on the relinquished property (if for example, a prime property is listed in a hot market, investors would have to write a contract quickly to compete with other prospective buyers).

Previously, reverse exchanges were used infrequently because the IRS offered no guidance on the topic. Reverse exchanges were considered a gray area, and taxpayers either proceeded with caution or chose to avoid them.

'Parking' Properties

In the past, there were three basic approaches to reverse exchanges: the "pure" reverse approach, the exchange-first (relinquished property parked) approach and the exchange-last (replacement property parked) approach. The first was dismissed by most QIs because the exchanger cannot own the relinquished property and the replacement property at the same time.

The goal was to create an arms-length transaction in which the QI (or an entity created by the QI) acquired either the relinquished property or the replacement property for the taxpayer and created an exchange, which should otherwise fall within the rules and regulations relating to deferred exchanges. The exchange-first and exchange-last approaches became known as parking arrangements because the QI "parks" one of the properties in the QI's name to prevent the exchanger from owning both properties simultaneously.

The problem of constructive ownership arose in these transactions. Although the QI held title to the property, all the benefits and burdens of ownership were transferred to the exchanger.

Questions regarding management of the parked property, loan arrangements, taxpayer advances to fund the acquisition, exit strategy, fixed price versus fair market value and who was to receive the tax benefits of ownership while the property was parked were common. If the taxpayer retained all the burdens and benefits of ownership while mere legal title was parked, it was feared the taxpayer would be treated as actually owning both the relinquished and the replacement properties at the same time.

New Rules for Reverse, Improvement Exchanges

After years of deliberation, the IRS has validated the parking arrangements described previously, as long as the exchange is completed within 180 days. Revenue Procedure 2000-37, enacted Sept. 15, 2000, creates a "safe harbor" for exchanges in which a third party called the "exchange accommodation titleholder" (EAT) enters into a parking arrangement and acquires title to either the relinquished or replacement property. This applies to reverse and improvement exchanges. More on improvement exchanges follows.

The EAT is the entity that parks the property. The EAT and QI can be the same, but preferably the EAT is a separate entity formed by the QI specifically for an exchange. Strategically applied, the new rules offer investors enhanced investment alternatives.

Seize a Buying Opportunity.

Investors can now immediately acquire a desirable replacement property before selling the relinquished property. Many commercial investors are using this strategy, particularly in markets where inventory of properties is low or turns over quickly. Investors can purchase their next investment property as soon as a good buy is available.

Guarantee Exchange's Buying End.