Wednesday, October 14, 2009

Reversal of Fortunes: Giving Power to the Investor through the 1031 Reverse Exchange

Net Lease Insider sat down for an interview with Stan Freeman, President of Exchange Strategies Corporation, the nation’s only 1031 reverse exchange accommodator dedicated exclusively to providing a full set of reverse exchange processes for all asset categories to qualified intermediaries and sophisticated exchangers. He provided excellent insights into the reverse exchange process, ranging from cost effectiveness to asset security.

1. How do investors take advantage of reverse 1031 exchanges in today’s difficult investment real estate market?

First, it is unfortunately true that many investors’ gains have been seriously eroded over the last 18 months. 1031 exchanges have fewer benefits for these folks. If someone does have potential benefits from a 1031 (either the deferral of gains or renewed depreciation potential), then the issue with making a new acquisition in the context of an exchange will likely be finding a buyer for the old asset.

To that end, reverse exchanges have been used for years by investors to better control the outcome of their investment strategies. At no time in recent memory has this been more important. Using a reverse exchange, an investor can acquire what they really want without the pressure of the standard 45 and 180 day deadlines applied to new assets. Most investors would rather be under pressure to sell what they have and not under pressure to buy something they might really not want. Furthermore, in many situations, reverses can be structured to provide more time – up to a year or perhaps more – to a accomplish a particular strategy. In today’ market, this can make all the difference.

2. How do you use a reverse exchange to get more time?

There are various ways to combine exchanges to get up to two 180-day periods. Generally, this is done when there are multiple properties to sell or buy. As an example, suppose you have an older apartment building to sell and you want to buy two new net-lease properties. If you start a reverse with the first of the new properties, then you have up to 180 days to sell the old property. Once it gets sold, in the context of a forward exchange, you have another period of 180 days to acquire the second new property. This type of strategy can also work if you have multiple old properties and a single new property to acquire.

There are also forms of reverse exchange that allow a new property to be improved prior to title being transferred to its ultimate buyer, thereby increasing its value for purposes of deferring more gain. This can also work with leaseholds. Both forms allow the investor more time to make improvements that bring a property to a full income producing condition.

In addition, there exist non-safe-harbor structures that require a great deal more care to implement. They are more complex and expensive and should be considered when the gains from the sale of an old property are substantial and there is real potential based on a either a series of new property acquisitions over a period of time or a construction project that will require a lot more than 180 days to complete. There are situations in which these structures make a great deal of sense.

3. But, I have the impression that reverse exchanges are very expensive. Isn’t that an impediment to using them as you suggest?

Investors with properties that produce healthy income will almost always find that a reverse is economically sound. The investor can earn the rents from both the old and new properties for up to 180 days if they are using a reverse exchange. So, if this income is greater than the reverse exchange fee plus the cost of funds needed to acquire the new property, the economics are significantly better than in a delayed exchange. Of course, a detailed analysis of the exchange economics for a specific situation is probably more complex than this. But it is always worth doing and we help our clients through the analysis on a regular basis.

4. These days, many investors are hesitant to use 1031 exchanges at all because of the numerous instances of theft and bankruptcy. Is there a reason to be nervous?

A reverse exchange is a title-parking arrangement. There is no cash, per se. And, there are well established methods of insulating assets from liability, bankruptcy and failure to execute. There is really no asset risk in a reverse exchange if it is structured properly.

Regarding the spate of QI failures, it is the accumulation of a large amount of cash proceeds – often following the acquisition of one QI by another – that has proved too tempting for some. The exception to this was the situation involving a large title-company-subsidiary in which securities were purchased with exchanger funds that became illiquid. The motivation was to increase the earnings on the cash it held. When selecting a QI for a delayed exchange it’s important to use one that allows you select the bank where proceeds are parked and is bonded and insured.

None of these issues pertain to reverse exchanges.

Perhaps choosing your accommodator for a reverse exchange requires some additional care in light of these cash-drive failures. If the QI you choose is heavily dependent on delayed exchanges and if their business is under stress because of the decline in exchange activity, then you should make sure that the LLC they form to hold your assets is fully protected from a decision they’d make to seek protection from a bankruptcy court. The entanglement that can occur if the LLCs are not structured right can be lengthy and difficult.

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