What Is a Reverse Exchange and How Does One Work?

Real estate investors know about the powerful tax-deferral opportunities of a 1031 exchange. By selling existing investment or business property and then replacing it with “like kind” property, capital gains tax can be deferred (in some cases indefinitely).

But what happens when an investor finds the ideal replacement property before they sell their existing investment property? Do they have to pass up the opportunity to acquire the perfect new investment simply because they haven’t sold their unwanted property? No. And here’s why.

An investor simply needs to understand and implement a “reverse exchange.”

This type of 1031 exchange allows an investor to acquire replacement property before selling relinquished property. Of course, the IRS imposes strict compliance rules surrounding reverse exchanges. Provided that an investor adheres to these safe harbor provisions, the validity of the reverse exchange should be assured.

Holding Title: Title to the replacement property must be held by the qualified intermediary (QI) upon purchase. The QI will continue to hold title until the sale of the relinquished property is completed, at which time title for the replacement property will transfer to the investor.

Five Day Rule: A “Qualified Exchange Accommodation Agreement” must be entered into between the investor and the QI within five business days after title to the property is taken by the QI in anticipation of a reverse exchange.

45-Day Rule: The relinquished property must be identified within 45 days of acquiring the replacement property. Just as with the more traditional delayed exchanges, more than one relinquished property can be identified, so long as the same rules (Three Property Rule, 200% Rule, 95% Rule) are followed.

180-Day Rule: The entire reverse exchange must be completed within 180 days of the QI taking title to the replacement property.

But what happens if the investor cannot find a buyer within the 180 days? There are a few options. The investor can simply terminate the exchange, take title to the replacement property and deal with any capital gains taxes when/if they sell the relinquished property (presuming they don’t attempt another exchange later on).

Alternatively, the investor can continue with the reverse exchange outside the protection of the safe harbor provisions noted above. The safe harbor time limits are not mandatory in a reverse exchange. However, when an exchange does not comply with these rules, the exchange is at a higher risk of challenge, audit and potential rejection by the IRS.

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