EAT 2000-37 Reverse Exchange Into a REIT
Carl E. Sera, CMT
August 29, 2023
If you're looking to sell real estate and defer capital gains taxes, there are many strategies that you can use. This strategy, in particular, allows you to close on a new property in the form of a Delaware Statutory Trust that will then be absorbed by a major REIT. While a forward exchange into a DST then REIT can be an excellent tax deferral strategy, a reverse exchange into a REIT flips the concept on its head and makes sense for real estate investors who have the cash on the sidelines and are planning on listing, selling, and closing on their relinquished property in less than six months.
John wishes to carry out a tax-deferred exchange in accordance with Internal Revenue Code Section 1031. Several months ago, John discovered an investment property and signed a contract to purchase it. John has been actively selling five investment homes since that time, but has had little success in getting purchasers. The contract for the replacement property is about to expire, and the seller has informed John that it will not be extended.
John does not want to lose this replacement property, but he does want to conduct a tax-deferred exchange. To complete a reverse exchange, enter into a Qualified Exchange Accommodation Agreement (QEAA) in accordance with IRS Revenue Procedure 2000-37 (Rev. Proc. 2000-37).
Understanding Reverse Exchange Under Rev. Proc. 2000-37
Reverse exchanges are done under Rev. Proc. 2000-37 by "parking" either the replacement property or the relinquished property with a third party until the actual exchange of properties can take place.
In the aforementioned scenario, John would seek out a third party ready to act as an Exchange Accommodation Titleholder (EAT) and assign the replacement property purchase contract to the EAT. The EAT would acquire title to the replacement property using cash given by John or a lender and would maintain title to the replacement property until John is able to sell one of the investment properties (relinquished property).
The contract for the sale of the relinquished property would be assigned to a Qualified Intermediary (QI), and title would be transferred to the QI, who would then transfer it to the buyer. The QI would then use the sale proceeds to acquire the replacement property from the EAT and transfer the replacement property to John to complete the exchange.
How Does the Safe Harbor Operate Under Rev. Proc. 2000-37
The IRS released Revenue Procedure 2000-37 to clear up some of the misunderstanding in this area, promote "sound tax administration," and offer taxpayers with a realistic method of completing reverse exchanges. This directive establishes a safe harbor for taxpayers who enter into "qualified exchange accommodation arrangements” (QEAAS) on or after September 15, 2000.
If the transaction is structured as a QEAA, the IRS will not question the qualification of property as replacement or surrendered property, nor will it contest the AT's status as the beneficial owner of the property under Revenue Procedure 2000-37. As a result, Revenue Procedure 2000-37 only applies to reverse swaps that qualify as QAEEs. A reverse exchange must meet six requirements to become a QAEE:
The property is held by an Exchange Accommodation Titleholder (EAT) - a person who is not the taxpayer or a disqualified person and who is subject to federal income tax. (If this person is a partnership or an S corporation 90% of partners or shareholders must be subject to federal income tax.)
The Taxpayer must have a bona fide intent that the property be held as either replacement property or relinquished property in a qualifying exchange when transferring it to the EAT.
A written agreement must be entered into within five business days after the transfer of the property to the EAT that provides that:
a) Property is held for the benefit of the Taxpayer in order to facilitate an exchange under 1031 and Rev. Proc. 2000-37;
b) Taxpayer and EAT agree to report the acquisition, holding, and disposition of the property as provided in Rev. Proc. 2000-37; and
c) EAT will be treated as the beneficial owner of the property for all federal income tax purposes.
No later than 45 days after the transfer of the replacement property to the EAT, relinquished property must be identified in a manner consistent with the principles for identifying replacement property found in 1.1031(k)-1(c)(4) of the Treasury Regulations.
No later than 180 days after the transfer of the property to the EAT, the property is transferred to the Taxpayer as replacement property or to a person other than the Taxpayer or a disqualified person as relinquished property.
The combined time period that the relinquished property and the replacement property are held does not exceed 180 days.
As a result of requirement four, John in the example must identify three potential relinquished properties within 45 days, or any number of potential relinquished properties as long as the aggregate fair market value of the identified relinquished properties does not exceed 200% of the value of the replacement property, or any number of potential relinquished properties regardless of their value, provided 95% of the identified relinquished properties.
Reverse Exchange Into A REIT
One of the questions we get often at Sera Capital is that, can an individual do a 1031 exchange directly into a REIT? The technical answer which may surprise many investors is “NO” – at least not directly. As many of our clients already understand, funds in an Exchange can only be reinvested in “like-kind” properties. Shares in a company are not considered “like-kind” and therefore direct investments into a REIT or any other company’s shares are not permitted.
Exchange money, on the other hand, can be invested in properties constituted as a Delaware Statutory Trust (DST). Over time, some DST sponsors have developed a DST option that includes both DST and REIT structures. Investors in these offerings first invest in a DST, and then the Sponsor will offer or, in some situations, require that the DST's interests be acquired by an affiliated REIT through a tax-neutral procedure known as a 721 Exchange.
If this serial process is correctly followed, the outcome for the investor is that they eventually end up with all their exchange funds now being invested in REIT shares. However, while no taxes are due when DST funds are first converted into REIT shares, the investor will lose the ability to complete a future 1031 Exchange with those funds.
Thinking of doing a reverse exchange, or want to do a 1031 exchange into a REIT? At Sera Capital, we are open for business and stand ready to assist you with your exchange transaction.
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