Recently, I read a bit about the famous trial attorney, Clarence Darrow. Darrow can easily be counted among the most well-known attorneys in American history. He took part in a number of famous cases, including the Leopold and Loeb case in 1924, during which he famously argued against the death penalty.
Darrow was an exceptionally gifted speaker, and he was known for being a passionate advocate for his clients. While reading about him, I couldn’t help but think about how important it is to have a strong advocate in challenging situations. Sometimes, the difference between a qualified advocate and an ill-prepared one can make a world of difference.
Reverse 1031 exchanges can be classified as one of these challenging situations. They come with a bit more complexity compared to a regular 1031 exchange, so you want to make sure you partner with someone who will make your exchange go as smoothly as possible. You want to find a good advocate, a supporter who will make the whole experience better.
When you decide to pursue a reverse section 1031 exchange, you will need to select an exchange accommodation titleholder (EAT). An EAT is similar to a qualified intermediary (QI), and it is possible that your QI can take on the role of an EAT. However, the key difference is that your EAT has the specific role of holding the legal title to either your replacement property or relinquished property prior to the completion of your exchange. Your QI is in charge of transferring funds from one source to another, whereas your EAT acts as a “safe harbor” where you can temporarily “park” the title of either the property you seek to acquire or the property you’re releasing.
Choosing an EAT is not an easy task. In addition to the general rules, which would also apply to selecting a QI, there are a couple of specific things to look for when choosing an EAT. We’ll go over these two things in detail, but first, let’s just briefly discuss the basic mechanics of a reverse 1031 exchange.
Replacement Property Is Acquired First in Reverse 1031 Exchanges
The basic mechanics of a reverse section 1031 exchange are actually pretty simple: In a reverse exchange, the new property you are trying to obtain—the “replacement property”—is identified and acquired first before you release title to your current property. In this way, the exchange is seen as occurring backward and so this is where the term “reverse” exchange comes from.
In this reverse exchange, the title to either your current property or the replacement property will be held for a period of time by your EAT. If your EAT temporarily holds title to your replacement property, this is referred to as an exchange last transaction. When your EAT holds title to your relinquished property, this is referred to as an exchange first transaction.
In future articles, we’ll go further into the details of reverse exchanges, but for now, it’s just important to know that the key thing about reverse exchanges is that they involve obtaining your replacement property first.
Select a Creditworthy EAT to Minimize Your Financial Risk
When you go about selecting an EAT, perhaps the most important thing you need to consider is the creditworthiness of your prospect. When you park your property with your EAT, the EAT holds the full legal title for a short span of time. This means that if the EAT happens to file for bankruptcy protection while holding your property, your property can be lost and you may suffer a severe financial setback as a result.
For this reason, you should be absolutely certain that the institution you select to act as your EAT has an excellent credit history. It’s important to do research on your prospective EAT and ensure they haven’t been involved in any controversies or financially unwise transactions. For instance, if you find a potential EAT has had multiple projects fall through, this may be a red flag, and it may be prudent to avoid partnering with them. You can also perform a business credit check to determine the financial condition of your prospective EAT.
To better minimize your financial risk, you also should make sure that your EAT is willing to set up a limited liability company (LLC) for the express purpose of holding the property during your exchange. Setting up an LLC for this purpose won’t completely eliminate your risk, but it will at least put you in a better position in the event that your EAT does file for bankruptcy.
If your EAT files for bankruptcy, you will have a better chance of recovering your property if it is placed in an LLC because you can make a claim that the asset (i.e. the property) was not directly “owned” by your EAT, but it was only held for the purpose of later transferring to you. Again, placement in an LLC will not guarantee this outcome, but it will theoretically put you in a better position.
Choose an EAT That Is Unlikely to Be Merged During Your Reverse Exchange
The other thing you need to look for is the likelihood that your EAT will be merged with a different company during the time it holds your title. If your EAT merges with another company while it holds title to your property, this could lead to your property being assigned to a different entity. And if your property is assigned to a different entity, this could create issues when you attempt to recover title at the tail end of the transaction. Although a merger transaction will not necessarily lead to tax issues for you, it is best to select an EAT that will not take part in this type of transaction just to avoid even the possibility of complication.
Remember, during a reverse exchange, the EAT literally has full legal title to your property, and so if the EAT should change its identity through a merger, this could create complexity when your property needs to be deeded to you. To add a layer of protection against this type of risk, your qualified exchange accommodation agreement—which is the contract established by you and your EAT to acknowledge the procedures of the IRS—should state that your EAT is not permitted to assign the title of your property to any other entity.
These two items—checking for creditworthiness and ensuring your EAT won’t merge with another organization—are the two items that are undoubtedly among the most important when you’re selecting an EAT. If you select a capable, creditworthy, and qualified EAT, your reverse 1031 exchange is much more likely to go through without any major hiccups or hassle.
CWS Capital Partners can be a fantastic resource when it comes to selecting an EAT. We’ve been involved with many reverse exchanges and work with some of the top EATs in the industry. By partnering with us for your reverse 1031 exchange, we can help ensure you’re working with the best advocates for your transaction. Contact CWS Capital Partners today to learn more and get started on your reverse 1031 exchange.
The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
All investments involve risk including the possible loss of principal. You should familiarize yourself with all risks associated with any investment product before investing.
Advisory services are provided by CWS Capital Partners LLC, a registered investment advisor.
Securities offered by CWS Capital Partners LLC are through an affiliated entity, CWS Investments. CWS Investments is a registered Broker Dealer, member FINRA, SIPC.