What is a reverse exchange and how does it work?

Real estate investors are aware of the powerful tax deferral opportunities of a 1031 exchange. By selling existing investments or commercial properties and then replacing them with “like” properties, capital gains tax can be deferred (in some cases indefinitely).

But what happens when an investor finds the ideal replacement property before selling their existing investment property? Do they have to pass up the opportunity to acquire the perfect new investment simply because they have not 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 the ceded property. Of course, the IRS imposes strict compliance rules around reverse trades. As long as an investor adheres to these safe harbor provisions, the validity of the reverse exchange must be ensured.

Holding title: The Qualified Intermediary (QI) must have title to the replacement property at the time of purchase. The QI will continue to hold title until the sale of the relinquished property is completed, at which point title to 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 the QI takes title to the property in anticipation of a reverse exchange.

45 day rule: The relinquished property must be identified within 45 days of the acquisition of the replacement property. As with more traditional deferred exchanges, more than one ceded property can be identified, provided the same rules are followed (three property rule, 200% rule, 95% rule).

180 day rule: All reverse exchange must be completed within 180 days after the QI takes title to the replacement property.

But what if the investor cannot find a buyer within 180 days? There are a few options. The investor can simply rescind the exchange, take title to the replacement property, and deal with capital gains taxes when / if he sells the ceded property (assuming he does not attempt another exchange later).

Alternatively, the investor can proceed with the reverse exchange outside of the protection of the safe harbor provisions mentioned above. Safe harbor time limits are not required in a reverse exchange. However, when an exchange does not comply with these rules, the exchange runs a higher risk of challenge, audit, and possible rejection by the IRS.