The IRS closely oversees the eligibility of 1031 exchanges to ensure that taxpayers adhere to the rules in order to receive the potentially substantial benefits of the transaction. A 1031 exchange can allow an investor to defer the capital gains taxes that would be due on the sale of their investment property if they reinvest the entire proceeds (not just the gain) into a “like-kind” replacement property within 180 days.
A 1031 exchange is a tool that may allow investors to defer payment of capital gains taxes when they sell one property and reinvest the proceeds in another “like-kind” property. 1031 exchanges are restricted to the exchange of investment real estate (property either used to run a business or held for investment). House flipping or property upgrades and improvements are not typically eligible for the transaction.
Investors must usually engage the services of a Qualified Intermediary, also known as an Exchange Accommodator, to execute the transaction. One primary reason for this requirement is that the investor may not have access to the proceeds from the initial sale during the period between that transaction and the completion of their purchase of replacement property.
The investor must identify potential replacement properties within 45 days of the sale and must complete the transaction (purchasing property with a value at least as great as that of the property sold) within 180 days.
In a reverse exchange, the taxpayer identifies the replacement property before selling the asset designated for relinquishing. This scenario may complicate the transaction. The IRS issued Revenue Procedure 2000-37 to clarify and simplify the process. The procedure is also referred to as a QEAA, or qualified exchange accommodation agreement, and it creates a safe harbor option for reverse exchanges.
The QEAA is an agreement made between the investor and the exchange accommodation titleholder (EAT), who, in this case, serves as the Qualified Intermediary. The two parties must enter into the agreement within five days of the date the property is "parked" with the EAT, and legal ownership is conveyed to that party. The IRS also requires that the taxpayer has a bona fide intent to replace the relinquished property indicated in the agreement.
The QEAA must state that the EAT holds the asset to facilitate a 1031 exchange for the taxpayer and must confer beneficial ownership to the EAT. Once that is done, the investor must complete the reverse exchange within the standard 180-day timeline.
The Revenue Procedure allows the agreement to include some elements that relieve the EAT of financial liability and enable the taxpayer to manage the property during the interim. Because the QEAA establishes the EAT as the beneficial owner, the taxpayer can loan money to the EAT to facilitate the purchase and make necessary improvements. The EAT can also lease the property to the taxpayer without reversing the grant of beneficial ownership.
If the taxpayer follows the requirements outlined in the Revenue Procedure, the IRS will not challenge the eligibility of either the replacement property or relinquished property for the 1031 exchange. However, taxpayers who do not fully satisfy the requirements may still attempt a reverse exchange.