What Is A Reverse 1031 Exchange?

Posted Aug 24, 2022


A 1031 exchange offers an opportunity for investors to reinvest the capital gains from selling an investment property without diverting a portion of the gain to pay capital gains taxes. This tactic can increase the buying power the investor can put to work in their next purchase, but it's a complex transaction, and strict rules and tight timelines govern it. For example, in an ordinary 1031 exchange, the clock starts ticking as soon as the investor sells the initial property, referred to as the relinquished asset.

Replacement timelines can be challenging.

They have 45 days to identify potential replacements, which must meet one of the below formulae:

Three property Rule

The three property rule allows the exchanger to identify up to 3 potential replacement properties regardless of value.

200% Rule

The 200% rule states that the exchanger may identify more than three potential replacement properties as long as their combined value does not exceed 200% of the sale price of the relinquished property.

95% Rule

The 95% rule allows identifying any number of properties with no reference to property value, but the taxpayer must acquire and close on 95% of the value identified.

Following that formal identification, the investor must complete the replacement transaction within an additional 135 days, or the exchange won’t succeed. Sometimes, the investor may not sell a property until they have a replacement property in their sights. They can then execute a reverse 1031 exchange by purchasing the identified replacement and selling the targeted sale property after that, using the same timeline.

What properties qualify for 1031 exchanges?

1031 exchanges are one of the tax situations in which the IRS offers some grace in interpreting the allowable execution. Of course, taxpayers must follow the rules, but there is considerable leeway in how to meet most of the requirements. For example, one key element of a successful 1031 exchange is purchasing "like-kind" property to replace the relinquished (sold) real estate. The IRS has interpreted "like-kind" as including virtually any investment property. The investor can sell a residential rental and buy a commercial office building or sell a self-storage facility and replace it with a solar farm. They can swap raw land for a hotel or student housing for a mall.   

However, there are rules to follow, and straying from those can disqualify the exchange. One area of concern is the definition of investment property. For example, if you are holding property for appreciation, the IRS does not consider that to be an investment property. Similarly, the transaction is not intended to be allowed for the flipping of residential property.

Safe Harbor rules for 1031-eligible properties.

A "safe harbor" means that you are safe from penalty if you meet certain conditions. The IRS has provided safe harbor guidance for investors to determine whether their property meets the definition of an investment asset. For residential rentals, the investor must have:

  •       Owned the property for at least two years
  •       Rented the dwelling to another person at fair market value at least 14 days within each 12 months
  •       Not have used the residence personally for more than 10 percent of the days it was rented to others (or 14 days) in each 12 months.

If commercial property is used in a business, the holding period of two years provides a safe harbor, although that period is not explicitly stated in the Internal Revenue Code.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Costs associated with a 1031 exchange may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. 

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