Delayed vs. Reverse Cost Comparison
The overwhelming majority of QIs in the US base their business on the profit potential from delayed exchanges. QIs aggregate their exchange proceeds into large deposits and generally earn favorable interest rates on them. Most QIs keep the majority of that interest and pay a small portion to their clients. The reality is that the Exchangor’s return on equity during a delayed exchange is usually drastically smaller due to this indirect way of compensating the QI for its services. This has enabled the typical delayed exchange fee to remain small relative to the value of the service performed.
Reverse exchanges have larger fees because there are no exchange deposits to profit from. Many QIs incorporate in their marketing and sales messages the idea that reverse exchanges are “more expensive” than delayed exchanges. While this can be true, depending on a particular set of facts and circumstances, it is not necessarily so. It is seldom a question of comparing the delayed exchange fee (typically between $500 and $1,000) with the fee for a simple reverse exchange (typically about $5,000). The real cost of a 1031 exchange must be evaluated using both fees and return on equity during the exchange period as the major factors.
In a delayed exchange, the Old Property is sold and the proceeds from the sale are entrusted to a QI until it is time to acquire the New Property. The Exchangor has therefore liquidated his investment asset and turned the equity from it into cash. That cash, in the hands of a QI, typically earns some fraction of “passbook” or “money market” rates for the Exchangor. If this interest rate were superior in terms of return on equity, there would be virtually no motivation to invest in real estate or other income producing assets. In other words, there is a cost, expressed in terms of lost return on equity, associated with performing a delayed exchange.
In a reverse exchange, either the Old Property or the new Property is “parked” with the QI. At the same time, the Exchangor is the beneficiary of a triple-net lease at zero rent which give the Exchangor 100% of the income potential from the parked property. Since the other asset involved in the exchange is also under the control of the Exchangor during the exchange, the Exchangor is receiving the financial benefit of two properties during the exchange. In other words, during a reverse exchange, there may be a return on equity stream coming from two assets and the benefit of this “leverage” belongs to the Exchangor and the Exchangor alone.
Of course, it’s seldom this simple. The Exchangor may have no choice about which form of exchange to use. Assuming that there is a choice, other factors have to be considered for each specific exchange. For example, the cost of money to acquire the new Property in a reverse exchange has to be taken into account. The length of the exchange period and the real return on equity from either or both properties may also make the comparison more difficult. The point is that developing the optimal exchange strategy for a particular exchange should include a calculation of the real cost of the exchange and that calculation should involve more than simply the fees charged by the QI.
We have provided a worksheet, available by clicking here or from Downloads, which contains an analysis of this type of cost comparison. The worksheet contains a detailed example. Feel free to modify the spreadsheet as you see fit. Of course, the worksheet is a tool only and we cannot accept responsibility for its accuracy, results or the consequences of any decision based on the results that it produces.