Buy First, Sell Later: Reverse and Improvement Exchanges

A standard 1031 exchange is “sell first, then buy.” But in New York, good properties go fast: what if you need to sign on the replacement now and your old property hasn’t sold? Or what if the replacement needs work: can exchange funds pay for the renovation? Those are the problems reverse and improvement exchanges are designed to solve.

Why Can’t You Just Buy First?

A 1031 exchange requires that you give up the old property before acquiring the new one. If you buy the new property in your own name first and then sell the old one, it generally cannot qualify as a 1031 exchange.

The solution is to have an Exchange Accommodation Titleholder (EAT) “park” one of the properties for you. The IRS provides a safe harbor for this in Rev. Proc. 2000-37.

How a Reverse Exchange Works

Method one: park the new property (more common)

1. The EAT (usually through a special-purpose LLC) buys and holds the replacement property, funded by your loan or third-party financing;
2. Within 45 days, you identify in writing the old property you will sell;
3. Within 180 days, you sell the old property, completing the exchange, and the EAT transfers the new property to you.

Method two: park the old property

The EAT takes title to your old property, you buy the new property directly, and the EAT then sells the old property to a third party within the deadline.

The key deadlines are the same as a standard exchange: 45 days and 180 days, with no extensions.

The Hard Parts of a Reverse Exchange

• Funding. Because the old property hasn’t sold, you must finance the purchase separately. Many lenders are unfamiliar with lending to a “parking LLC,” and underwriting can be more complicated;
• Cost. EATs charge higher fees, and there are LLC formation costs and additional title and legal fees;
• Transfer taxes and recording. In New York, moving title to a parking entity and then to you may involve additional transfer taxes, mortgage recording tax and recording fees. The structure must be designed in advance;
• You can’t park property you already own. Under IRS guidance (Rev. Proc. 2004-51), property you have owned within the previous 180 days cannot be parked under the safe harbor for a reverse exchange;
• Co-ops are nearly impossible. A co-op board will rarely approve a temporary LLC as a shareholder only to transfer the shares to you. Reverse exchanges work better for fee simple property and condos.

Improvement Exchanges: Using Exchange Funds to Renovate or Build

If the replacement property needs renovation, an addition or even new construction, you can use an improvement exchange (also called a build-to-suit exchange):

1. The EAT uses exchange funds to buy and hold the replacement property;
2. While it holds title, exchange funds pay for renovation or construction;
3. Within 180 days, the EAT transfers the property, with the completed improvements, to you.

The key limit: only improvements completed within the 180 days count toward the replacement property’s value. Work still unfinished at the deadline doesn’t count and may create boot.

Example: Your old property’s net sale price is $1.5 million. You buy a $1.2 million building and plan $300,000 of renovations. Only renovation work actually completed and paid for within 180 days counts toward the replacement’s value. If only $200,000 of work is done by the deadline, the other $100,000 may become taxable boot.

Improvement Exchanges in New York: What to Watch

• Permits and schedules. New York City Department of Buildings approvals and contractor schedules often take longer than expected. Completing $300,000 of work within 180 days is not easy;
• Do only what can be finished in time. You can split the work into phases, completing phase one within 180 days and finishing the rest with your own funds after the exchange;
• Contracts and payments. Construction contracts, payments and sign-offs must run through the EAT, coordinated by your attorney.

Attorney’s Insight

Reverse and improvement exchanges are advanced but expensive 1031 tools. They can help you secure a great property and put money where it counts, but they are complex, costly and unforgiving. Our advice:

• First ask: do you really need one? Often, negotiating a longer closing, or setting a later closing date in your sale contract, can turn “buy first” back into a standard exchange and save a significant amount;
• Design the structure before you sign the purchase contract. Once you sign, pay and take title in your own name, it is usually too late. The purchase contract should allow assignment to the EAT;
• Talk to your lender and title company early. In New York, the financing, transfer tax and recording issues in a parking structure are more complex than in many other states, and the sooner they are confirmed, the better.

Attorney’s perspective

Reverse and improvement exchanges require an extra holding arrangement and a tighter schedule. We design the structure with the intermediary and prepare the documents.

For advice about your own situation, call +1 718-218-5805 or schedule a consultation. We meet clients in Flushing and Manhattan, in English or Chinese.

Series overview

This article is for general information only and is not legal advice. Reading it does not create an attorney-client relationship. For advice about your situation, please contact us.

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