Why investors use a reverse exchange
Good apartment buildings do not wait for your sale to close. If you find the right replacement before your current property has a buyer, a forward exchange forces an uncomfortable choice: let the deal go, or buy it outside the exchange and pay tax on the sale that follows.
A reverse exchange solves that by acquiring the replacement first and selling the relinquished property afterward. It is also used when a seller wants a fast close, when the 45-day identification window in a forward exchange looks too risky in a tight market, or when an investor wants to build or improve a replacement property before the exchange is completed.
How it works: parking the property
The tax code does not let you own both the old and the new property yourself and call it an exchange. Instead, a reverse exchange uses an exchange accommodation titleholder, or EAT — usually a single-purpose entity formed by the qualified intermediary — to hold title to one of the properties temporarily. The IRS safe harbor for these arrangements is set out in Revenue Procedure 2000-37.
- Exchange-last structure: the EAT acquires and holds the replacement property. When the old property sells, the exchange closes and the EAT transfers the replacement to you. This is the most common approach.
- Exchange-first structure: you acquire the replacement property directly while the EAT takes title to the property you are selling and holds it until a buyer closes. It is used less often, partly because lenders on the old property must consent to the transfer.
- In either case, a qualified exchange accommodation agreement is signed within five business days of the EAT taking title, and the EAT typically leases the parked property back to you so you can operate it during the parking period.
The deadlines
The safe harbor uses the same two clocks as a forward exchange, running from the day the EAT takes title to the parked property.
- Within 45 days, you must identify the property you intend to sell, in writing.
- Within 180 days, the relinquished property must be sold and the exchange completed, with the parked property transferred out of the EAT.
- The deadlines are not extended for weekends or holidays, and missing them generally means the safe harbor no longer applies.
- Because you choose the property to sell before you start, the 45-day identification is usually the easy part. The 180-day sale deadline is where the risk sits.
Financing a reverse exchange
Financing is the hardest practical issue. You need enough cash or credit to buy the replacement property before the proceeds from your sale exist. Some investors use cash reserves, a line of credit or a bridge loan. Others arrange a loan from themselves to the EAT, which uses the money to buy the property.
Conventional lenders, and especially agency multifamily lenders, are often unfamiliar with or unwilling to lend to an EAT. Expect more underwriting time, additional legal documents and, sometimes, a requirement that you guarantee the loan. Talk to your lender and intermediary before you sign a purchase contract.
Costs and risks
Reverse exchanges cost noticeably more than forward exchanges because the intermediary forms an entity, holds title, signs loan documents and may carry liability for the property. Expect setup fees, legal costs for the parking documents, possible transfer taxes or recording costs in some states, and insurance for the parked property.
The main risk is that the old building does not sell within 180 days. If it does not, the safe harbor is lost, and you may be left owning two buildings with the exchange benefits in doubt. Price the relinquished property to sell, start marketing early and, where possible, line up a buyer before the replacement closes. A buyer who can close quickly and with certainty is worth more in a reverse exchange than a slightly higher price from a buyer who might not perform.
Improvement exchanges
A variation called a build-to-suit or improvement exchange uses the same parking structure to let the EAT make improvements to the replacement property during the 180 days, so that the value you receive includes the renovation. It can help investors who would otherwise trade down, such as an owner buying a building that needs significant work. Only improvements completed while the EAT holds title count toward the exchange value, so plans must be realistic about construction timelines.
