What Is a Reverse Exchange?
A reverse exchange in real estate is a type of property exchange wherein the replacement property is acquired first and then the current property is sold. A reverse exchange was created to help buyers purchase a new property before being forced to trade in or sell a current property. This may allow the seller to hold a current property until its market value increases, thereby also increasing their own timing to sell for maximized profit.
- A reverse exchange is a property exchange in which a replacement property is purchased without the sale of a currently-held property.
- Reverse exchanges differ from delayed exchanges, in which the replacement property must be purchased after the sale of the currently-held property.
- “Like-kind” exchange rules typically do not apply to reverse exchanges.
- Reverse exchanges apply only to 1031 properties and are only permitted in cases where investors have the financial means to make the new purchase.
How a Reverse Exchange Works
Standard like-kind exchange rules usually do not apply to reverse exchanges. Such rules typically allow a property investor to discontinue payment of capital gains taxes on a property they have sold so long as the profit from that sale is applied toward the purchase of a “like-kind” property.
The IRS has created a set of safe-harbor rules that allow for like-kind treatment, as long as either the current or new property is held in a qualified exchange accommodation arrangement, or QEAA. Additionally, the investor cannot use property already owned as a replacement for the relinquished property.
Reverse exchanges apply only to Section 1031 property, so it is also referred to as a 1031 exchange. Section 1031 properties are properties that businesses or those with qualifying organizations exchange in order to defer paying taxes on any profit gained from their sale.
However, it’s not as simple as an individual taxpayer buying one property, selling it, then using the profits to buy another property. Instead, there must be a set standard of exchange as well as the presence of a facilitator who is used to set up the process. Section 1245 or 1250 properties are ineligible for this type of transaction.
A “1031 property” gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows investors to avoid paying capital gains taxes in the process of selling and purchasing investment properties.
One of the most crucial aspects of a successful reverse exchange depends on the fact that the investor must have the financial means for the new purchase. The old property will not have been relinquished at the time of the exchange, so the investor must be capable of providing the full funding for the new property without the completed sale of the old one. Acquisition of the new property may be facilitated with a lender, although only specific lenders will be willing and able to work with a reverse exchange investor.
Requirements for Reverse Exchanges
Generally, there is a maximum holding period that applies to properties in reverse exchanges, typically averaging around 180 days. The opposite of a reverse exchange is the delayed or deferred exchange, in which an exchanger must first relinquish owned property by trading or selling before acquiring a new property.
Reverse exchanges are often used in cases where a property investor must close on the sale of a new property before being able to sell their current property. Cases such as these include the unexpected discovery of a desirable new property that must be purchased within a short amount of time or situations in which the sale of a currently-held property falls through unexpectedly, thus leaving a reverse exchange as a potential fix that allows the investor to continue the purchase of a new property.
The IRS issued Rev. Proc. 2000-37 to clarify the rules regarding reverse exchanges. The IRS says it will not challenge a property's qualifications as either a replacement property or relinquished property or the treatment of the exchange for federal income tax purposes provided the property owner follows the qualified exchange accommodation arrangement as outlined in the revenue ruling.
Even after the publication of the IRS ruling, some confusion still remained regarding how property owners should structure a reverse exchange and what the responsibilities were for the selected third-party exchange facilitator. In a 2017 ruling (Estate of Bartell, 147 T.C. No. 5, 2016), the Tax Court rejected the IRS's position that the exchange facilitator was required to take on the burdens and benefits of the property ownership in order to fulfill a valid 1031 reverse exchange.
Given that the rules surrounding reverse exchanges are evolving and can be challenging to interpret, property owners should consult with a qualified tax attorney or advisor before undertaking a reverse exchange.