1031 Reverse Exchanges: Navigating the Rules of the Road

Many savvy buyers of vacation and resort property, (particularly investors in this market niche), are already familiar with the concept of 1031 Exchanges. Less familiar and employed less frequently is another tax-saving provision allowed under the 1031 IRS code called ‘Reverse Exchanges’. Unlike the standard ‘Forward’ 1031 Exchange, the rules that govern a Reverse Exchange allow to for the acquisition of a’ like kind’ Replacement Property before the sale of the Relinquished Property.

Reverse 1031 Exchanges have been structured by legal and tax advisors for years without much help or guidance provided by either the Treasury Department or the IRS. Absent any official ‘rules of the road’ to guide them, investors and their advisers could only look to related tax court decisions that had been handed down to understand how to proceed.

Fortunately, Exchangers no longer have to rely on the educated guesses of their advisors regarding 1031 Reverse Exchange rules. The rules and guidelines about how to properly structure Reverse 1031 Exchange transactions are now included within the 1031 regulations.

There are two basic types of Reverse Exchanges, referred to as ‘Safe Harbor’ and ‘Non Safe Harbor’ Exchanges. Safe Harbor Reverse Exchanges require the Exchanger to complete the subject transaction within a 180-day period from the date the Relinquished Property is sold. The Non-Safe Harbor provision is used in instances when the Exchanger, for one reason or another, is unable to find or purchase a Replacement Property to use in the planned exchange within 180 days.

In brief, there are some basic rules governing Reverse 1031 Exchanges.
The Reverse Exchange must involve an “Exchange Accommodation Titleholder” (EAT). The EAT is an independent third party that holds, or ‘parks’, the Exchanger’s Replacement Property (following or prior to the exchange period). The EAT must have a qualified indicia of ownership (evidence of an interest in real or personal property securing a loan or other obligation) from the date of acquisition until ownership is transferred to the Exchanger.

Once a qualified EAT is designated, the Exchanger and his/her advisers must determine which of several types of Reverse Exchanges will be utilized. The so-called ‘Safe-Harbor Reverse’ is an exchange where the EAT parks the Replacement Property prior to the sale of the old property. Under this provision, the Exchanger must identify the Relinquished Property (or properties) within 45 days of the parking arrangement, and must have the entire transaction complete within 180 days of the parking arrangement.

A Non-Safe Harbor transaction is a Reverse Exchange that typically looks identical in structure to the Safe-harbor Reverse, but for whatever reason, will fall outside of the Safe-Harbor provision because it can not be completed within the prescribed time frame provided under this part of the 1031 rules. In a typical situation that triggers the use of the Reverse 1031 procedure, the Exchanger is unable to sell their old property within 180 days of the parking arrangement, and therefore the time frame to qualify the exchange under Safe-Harbor are not met. While this type of transaction is not necessarily a “red flag” that automatically increases the risk of an IRS audit, it does require quite a bit more documentation and consultation between the IRS and the intermediary to assure the transaction is done properly to avoid triggering an audit.

One attractive aspect of the Non-Safe Harbor Reverse 1031 Exchange is that they give the Exchanger the flexibility to take all the time needed to locate an ideal Replacement Property to meet their needs, without the pressure of the tight time frames mandated by the more restrictive Forward 1031 Exchange rules.

Perhaps the most powerful provision that falls within the guidelines governing Reverse Exchanges is the ‘Construction/Improvement Reverse’. Use of this process allows the Exchanger to park a piece of property or land that will be built on or otherwise improved during the exchange period. It allows the Exchanger great latitude to create the exchange property that they will eventually exchange

Even though the rules controlling 1031 Reverse Exchanges are considerably more complex (and therefore more expensive) than for a traditional, Forward Delayed Exchange, the use of the Reverse Exchange provision can prove worthwhile and profitable. It’s utility is easier to understand in light of how difficult it can be in some instances to identify and acquire replacement property within the time frame prescribed by the rules governing Forward Exchanges. In these cases, many investors who have used Reverse Exchanges have found negotiating the complexity of the Reverse Exchange to be well worth the expense.

This article was originally published in the Winter 2007 issue of 2ndhome® Specialist, a digital magazine for real estate professionals specializing in the second home and resort markets.