Can You Combine a Reverse and Forward 1031 Exchange?

For many real estate investors, the primary objective of completing a 1031 exchange is to defer capital gains taxes generated from the sale of their investment properties. 

There are other reasons why investors may want to complete 1031 exchanges, including portfolio diversification or attempting to manage concentration risk. Some investors also use the exchange process to trade multiple investment properties for one single property of greater value. 

Timing plays a crucial role in standard one-for-one forward 1031 exchanges, where investors sell their properties prior to purchasing replacement assets. Timing becomes even more important when multiple properties are involved because there likely will be multiple closing dates that prevent the exchangor from completing a standard forward 1031 exchange. 

In this instance, and in other scenarios, it’s possible to take a hybrid approach that combines a forward (also called a delayed) exchange and a reverse exchange to fully defer capital gains taxes on the sale of multiple investment properties. 

Here’s how it works. 

Combining a Forward Exchange with a Reverse Exchange: What You Need to Know 

As noted above, timing is one of the most important aspects of a delayed 1031 exchange. 

You have 45 days after the close of sale on your relinquished asset to formally identify up to three replacement properties, and a total of 180 days to wrap up the acquisition of your new asset. In order to avoid the burden of meeting those strict timelines – especially in instances when replacement properties are hard to find, or properties sell quickly – you may choose to complete a reverse 1031 exchange. In a reverse exchange, you’ll have your qualified intermediary (QI) purchase the replacement property prior to selling your relinquished asset. 

The replacement property in a reverse exchange can be “parked” for up to 180 days while you work to sell your original investment property. Reverse exchanges require careful planning and strategic execution, but in the end it’s still just a one-for-one exchange. The acquisition and divestiture processes are simply flipped from a forward exchange. 

Now let’s take a look at a scenario where you might want to consider a hybrid approach that blends a forward exchange with a reverse exchange.  

Say you own two investment properties that will fetch $1 million each. You want to reduce the amount of time required to manage both properties, so your objective is to sell both properties and buy one investment property worth at least $2 million so there will be no taxable boot generated during the exchange. 

Property A quickly receives a $1 million offer, but Property B has yet to see any investor interest. Meanwhile, you’ve found a great replacement asset and want to move forward with the acquisition, even though you only have half the money needed to purchase the replacement property. 

You accept the $1 million offer for Property A, and formally identify one-half of ownership in the replacement asset within the 45-day identification period. Your exchange accommodation facilitator (also called a qualified intermediary) will take title to that half of the property in your interest. This is the forward half of the hybrid exchange. 

Completing the reverse portion of the exchange can get a bit complicated. You’ll have to create an LLC that lists your QI as the sole member. You can lend this LLC the additional $1 million in funding needed to purchase the replacement property, which will be titled as one-half yours and one-half in the name of the LLC. Effectively you have entered into a tenancy in common with the LLC to own the target property. 

When Property B closes, the $1 million in sales proceeds are deposited into an exchange account that will acquire the other half of TIC ownership interest from the LLC you created. Your QI will transfer those funds to the closing agent to complete the reverse portion of the exchange, and the money that was lent to the LLC will be returned to you. 

It may seem a circuitous route, but it’s one that provides safe harbor in both halves of the exchange because it precludes you from ever taking constructive receipt of funds in the sale and purchase transactions. Of course, this path only works if you have enough liquidity to loan the LLC the funds necessary to complete the acquisition of the replacement asset. 

Putting it all Together 

In the example above, a hypothetical investor swapped two properties for one with a matching value of the combined assets. By blending a forward and a reverse exchange, the investor was able to fully acquire a replacement property and defer capital gains on the sale of both relinquished properties. 

There are other scenarios where this course of action may make sense for your financial situation. It can be a difficult undertaking, though, and likely requires the expertise and insight of professionals well versed in the taxation and legal issues associated with 1031 exchanges to ensure proper execution.