Reverse 1031 Exchange Rules
Under IRS rules, Internal Revenue Code Section 1031 states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment.” In a typical 1031 Exchange, a taxpayer must sell the old property, known as the Relinquished Property, before acquiring the new property, the Replacement Property. However, due to various circumstances, a taxpayer may risk losing the opportunity to purchase the desired Replacement Property if its closing date comes before the sale of the Relinquished Property. Sometimes, the Relinquished Property might already be under contract. Still, the closing is scheduled after the Replacement Property purchase or the Relinquished Property may not yet be listed or under contract. In such cases, taxpayers can utilize a Reverse Exchange.
What is a Reverse Exchange?
A “Reverse Exchange” occurs when a taxpayer needs to secure the Replacement Property before the sale of the Relinquished Property. The key to making a Reverse Exchange work is to restructure it so that it no longer appears “reverse” at all.
In 2000, the IRS introduced a set of guidelines providing a “safe harbor” for Reverse Exchanges under Rev. Proc. 2000-37. These are commonly known as “parking arrangements,” where either: (i) a property is purchased and “parked” by an exchange accommodation title holder (EAT) for the taxpayer’s benefit until the taxpayer can arrange the sale of the Relinquished Property, or (ii) the taxpayer transfers the Relinquished Property to an EAT, receives the Replacement Property, and later the EAT transfers the Relinquished Property to the buyer. Following these safe harbor rules allows taxpayers to structure a Reverse Exchange in compliance with IRS requirements.
Reverse Exchange Process
Let’s walk through how a Reverse 1031 Exchange works. Essentially, the IRS has made it easier than it may seem. By utilizing an EAT, a taxpayer can have the Replacement Property “parked” and held on their behalf. They then have up to 180 days to sell the Relinquished Property and complete the exchange. Since the taxpayer does not directly acquire the Replacement Property before the sale of the Relinquished Property, the transaction is executed in the correct sequence as per IRS rules. Though it may seem like a bit of “smoke and mirrors,” the technique is authorized by the IRS.
Financing in a Reverse Exchange
When considering a Reverse 1031 Exchange, financing is an important aspect. The EAT does not provide the funds to purchase the replacement property. Instead, this can be achieved through a loan from the taxpayer to the EAT, or via a bank loan. The loan is typically paid off once the Relinquished Property sells. During the period when the Replacement Property is held by the EAT, it is leased to the taxpayer, allowing them to sublease it to tenants, collect rent, and manage expenses. Ultimately, the EAT earns a fee for its services, while the taxpayer retains the economic benefits.
Cost of a Reverse Exchange
The cost of a Reverse 1031 Exchange varies based on several factors, including property type (residential, commercial, industrial), property value, and the source of financing (taxpayer-funded or bank-financed). Additional considerations, such as environmental issues, may also impact costs. Since the exchange company holds the title, these variables play a role in determining the overall expense.
Relationship of Reverse Exchange and Forward Exchange
There is often confusion between Reverse Exchanges and Forward Exchanges. Taxpayers may ask, “Why do I need a Forward Exchange if I’m doing (and paying for) a Reverse Exchange?” Although they relate to a single transaction, they are separate but essential parts. The Reverse Exchange allows the Replacement Property to be secured, preserving the taxpayer’s ability to exchange for it. Technically, a Reverse Exchange is not a 1031 Exchange but rather a mechanism to facilitate one. The Forward Exchange is the actual 1031 Exchange, where the Relinquished Property is sold and replaced. Both processes are necessary to complete a successful Reverse Exchange.
The Forward Exchange is handled by a Qualified Intermediary under a different set of IRS rules than those governing an EAT providing Reverse Exchange services. It is possible to use a single company, like InSight 1031, to act as both the EAT and the Qualified Intermediary, or separate companies specializing in one type of exchange service.
The content in this blog is intended for informational purposes only. It is not to be construed as investment, legal, tax, or compliance advice. InSight 1031 operates as a Qualified Intermediary, facilitating tax-deferred exchanges under Section 1031 and does not provide investment, legal, or tax advisory services.
