Reducing the Risk of a Failed Exchange
In a delayed exchange, the Exchanger has 45 days to identify candidate New Property and 180 days to acquire New Property from among those properly identified. If no 45-day identification takes place, the QI is required by law to return the Exchanger’s cash and the exchange fails, resulting in no deferral of the tax on the gains resulting from the Old Property sale. If the 45-day identification does occur but the Exchanger realizes that the exchange is going to fail (if the identified property is sold to somebody else, for example), the QI is required by law to hold the Exchangers cash for the full 180 days before it can be returned. These restrictions are statutory and there is no flexibility regarding their application. Finding desirable New Property, getting the necessary credit arrangements in place and closing acquisitions have become significantly more difficult in the last 2 years and the risk of a failed delayed exchange has increased accordingly.
By contrast, a reverse exchange is started when the New Property is acquired. The Exchanger then has 45 days to identify potential Old Property to be sold. It is critical to appreciate this difference: identifying potential New Property (in a delayed exchange) may result in far more risk of exchange failure due to increased risk of not being able to acquire what has been identified. In a reverse, the Exchanger is required to identify using assets it already owns and therefore has more chance of successful completion of the exchange due to the ability to influence the sale of Old Property.
Furthermore, if a reverse exchange is in danger of failing because the Old Property cannot be sold, the possible outcomes are generally more attractive. First, the Exchanger may simply elect to let the reverse exchange fail and end up with direct title to both the New Property and the Old Property. This may place some stress on the financials of the Exchanger but the Old Property can, hopefully, be included in another exchange at a later time. The benefit of this approach is that there is no capital gain tax to defer since no sale of the Old Property has occurred! Secondly, the Exchanger has the option to “extend” the exchange using a process that involves non-safe-harbor structures to complete the reverse exchange while providing more time to sell the Old Property. The cost and complexity of this approach have to be carefully evaluated and compared to the tax problem at hand. It is, however, an option that simple does not exist with delayed exchanges. See our section on Extensibility for more.