In Like-Kind Exchanges, Reverse Can Be More Impactful Than Forward

Jonathan Hipp

Optimizing your investment strategies, while always the goal, becomes a critical focus in uncertain economic environments. In times such as these, options are always key to moving ahead on the placement of capital. The more investment tools you have at your disposal, the more flexible you can be when weighing your next capital play.

This is especially true if you are an investor interested in 1031 like-kind exchanges.  The more common form of forward exchanges carries risks of identifying the replacement asset by pre-determined deadlines, typically 45 days. By contrast, in the far less common reverse-exchange model, the investor acquires the replacement asset first, profoundly changing the deadline pressures of identifying a property within 45 days of the sale of the relinquished property, which eliminates the possibility of being a buyer, possibly a desperate buyer, in a market that continues to be very tough for finding good-quality assets at workable terms. Although sales activity is down in 2023, the market has demonstrated that a good-quality asset, properly priced should be sold within the 180-day period permitted under the reverse-sale regulations.

We must state that reverse exchanges do come with requirements that might not fit certain investors. As Stan Freeman, president of Exchange Strategies Corp., explains, the most obvious of these is ponying up the capital—cash and debt—for the replacement property before gaining access to the funds from the relinquished asset. In addition, the fee that goes to the qualified intermediary is likely to be higher than it would be on a forward exchange. The investor would also have to shoulder the temporary responsibility of operating both assets until the exchange is complete.

But, that said, keep in mind also that the investor will be enjoying the rent and depreciation deductions from the current asset and the rental income generated by the replacement property. Finally, immediately upon the closing of the sale, the cash proceeds go directly to the investor.

By comparison, the real cost of a typical forward exchange is quite high. As Freeman points out, what is optimal for the qualified intermediary is not necessarily so for the investor. The intermediary receives their fee while paying little if any interest on the investment capital they are holding. Finally, both the rental income and depreciation will go away once the property sells.

Other Benefits of Moving in Reverse

A couple of additional “features” of reverse exchange are worth noting. First, if an investor starts a reverse exchange and then decides, for whatever reason, not to sell a relinquished property, then there has been no “taxable event” and there is no gain on which taxes must be paid! Secondly, there are certain situations where more than 180 days are available to sell the relinquished property in a reverse exchange. While usually much more complex, these “extended” exchanges can be very useful if more time is needed.

As I stated above, the name of the game in investments is options, and that truth is played out larger in uncertain economic environments. The reverse exchange is simply another of those options. It requires a close working relationship with your lending association and your broker. And as we always emphasize, due diligence on the specifics of the property and its market is also key. These exchanges are governed by tax rules, so consult with your legal and tax advisors throughout the process.

Let’s apply these issues to a hypothetical forward exchange case. Let’s say investor Barry has an income-producing property with a current full-market value of $2 million—double the value of the purchase price eight years ago. The property generates rental income at a 6.5 percent cap rate relative to the original $1 million investment. Simultaneously, Barry wants to cash in some legacy T-bills and municipal bonds (currently earning 1.5 percent) to fund the purchase of a new property at $3 million (at a cap rate of 6.5 percent). But finding a property with those specs is difficult, and the qualified intermediary will hold Barry’s $1.4 million in equity until he finds that elusive replacement asset. Once Barry sells, we could be hard-pressed to identify candidates within 45 days and if he does not, the exchange will fail and he’ll be stuck paying taxes on the gain

While his broker scouts out the replacement property, Barry’s net rental income drops to zero, as does the monthly depreciation deduction. In addition, Barry must pay a one-time exchange fee of $1,000 which is partially offset by $117 in monthly interest on exchange funds. Assuming a three-month exchange period, the waiting period will cost him $650.

By contrast, in a reverse exchange, Barry will collect rents from two properties. Yes, he may have debt service to pay on two loans and the fee for the exchange is higher. But on the first score, the arbitrage between the cap rates and the cost of the debt is usually attractive. On the second, the fee is more than offset by the overall ROI generated by his $2.1 million during the exchange period. Lastly, when the exchange is complete, typically in 6 months or less, he’ll have immediate access to the $1.4 million in equity from the relinquished property and can use it to replenish the cash he contributed to the purchase of the replacement and/or reduce the loan balance.

We repeat there are both benefits and burdens attached to reverse exchanges, including the enjoyment of collecting two rents and perhaps servicing two loans. Given current cap and interest rates, a reverse exchange, carefully executed, will in most instances produce positive net monthly income and returns far superior to those of a traditional forward exchange.  There are also advantages of a reverse exchange in managing the risk associated with exchange deadlines in today’s market.

Lastly, it should go with saying that you should always work with advisors including qualifying intermediaries, tax professionals, real estate attorneys, and real estate brokers.

Jonathan Hipp is head of the U.S. Net Lease Group at Avison Young.