Many 1031 exchanges – swapping one investment property for another in order to defer capital gains and depreciation recapture tax liabilities – are completed as forward exchanges where investors sell relinquished assets and close on replacement properties within 180 days.
An avenue that’s not as common but remains available to real estate investors is the reverse 1031 exchange. In this type of transaction, investors acquire a replacement property prior to selling their relinquished assets. The process can be very complicated, and investors must strictly adhere to Internal Revenue Service guidelines to ensure their exchanges are not challenged or invalidated.
Below we’ve outlined the safe harbor guidelines issued by the IRS for completing reverse exchanges.
One main caveat of reverse exchanges (and perhaps a primary reason why they aren’t very common) is that investors must have the financial wherewithal to fully acquire replacement properties without having any of the funds that will be generated from the sale of their relinquished assets. For some real estate investors, that may put completing reverse exchanges out of financial reach.
Investors who do have the financial strength to complete reverse exchanges can look to Rev. Proc. 2000-37 for guidance on safe harbor to ensure the IRS won’t challenge their replacement or relinquished exchange assets.
The gist of the ruling is that the replacement property cannot be acquired by the exchangor; rather, it must be held in a qualified exchange accommodation arrangement (QEAA) in order to qualify for non-recognition of loss or gain. This type of “parking” acquisition structure has some restrictions, though.
The following conditions must be met in order for the exchange accommodation titleholder (EAT) to be treated as the beneficial owner of the replacement asset:
Exchangors who adhere to these stipulations should enjoy the protections provided by safe harbor. Reverse exchanges can still be completed outside of these transaction guidelines, but they will be done outside of the structure provided for safe harbor.
There can be several benefits for undertaking reverse exchanges. Investors can take their time locating the most suitable replacement assets without having to worry about the short 45-day identification window that starts when they sell relinquished properties in a forward exchange. They are afforded more time to market and sell relinquished assets, so they could potentially secure a higher price for their properties. They also can complete renovations or improvements to the replacement asset if they are relocating a business or tenant.
Reverse exchanges aren’t without potential drawbacks, though. The process requires precise planning, as well as increased financial strength since investors cannot use sale proceeds from their original assets to help fund the purchase of their replacement properties. However, investors who comply with the IRS guidelines on reverse exchanges should enjoy safe harbor on these transactions.