Generally, a taxpayer, also referred to in this article as an investor, must recognize a gain or loss on the sale or other disposition of real property pursuant to Internal Revenue Code of 1986, as amended (Code) sections 61(a)(3) and 1001. However, section 1031 of the Code provides an exception allowing an investor to defer the recognition of a taxable gain or loss on the exchange of real property held for productive use in a trade or business or for investment if the property is exchanged “solely for property of like-kind.”

Most 1031 exchanges are structured as a forward 1031 exchange where the relinquished property is sold before the replacement property is purchased. Investors often fail to consider a reverse exchange where the replacement property is acquired prior to the relinquished property being sold.

In a competitive real estate market with low inventory, a reverse exchange can serve as a valuable tool for investors. It allows them to close quickly on a replacement property since the investor does not need to wait on the sale of its relinquished property in order to purchase the replacement property to defer taxable gain. A reverse exchange also eliminates a huge risk associated with the process of conventional 1031 exchange. An investor may not be able to acquire a desirable replacement property upon the sale of relinquished property within the tight time frame allowed by the IRS, thus resulting in payment of unnecessary capital gain taxes.

In order for a reverse exchange to qualify for Section 1031 treatment, the investor cannot own both the relinquished property and the replacement property at the same time or the exchange will fail. Despite closing on the purchase of a replacement property prior to the sale of the relinquished property, the investor can only take legal title to the replacement property until after the sale of the relinquished property is completed. Authority issued by the IRS provides a safe harbor for so-called “parking arrangements,” which can be utilized as a workaround when the investor must acquire the replacement property before it has sold the relinquished property.

This can be done by by engaging an Exchange Accommodation Titleholder (EAT) which will take title of either the relinquished property or the replacement property until the investor has completed the sale of the relinquished property and 1031 exchange is complete. An EAT typically creates a special purpose entity to temporarily hold title to the property until the relinquished property is sold.

It is important to note that there is a time component to the identification of the relinquished property in a reverse 1031 exchange. The investor must identify its relinquished property as the property to be sold in the reverse exchange within 45 days of the closing of the replacement property. The IRS safe harbor provision permits an EAT to hold title for a total of 180 days from the purchase of the replacement property and within which the relinquished property must be sold to a third-party purchaser.

Reverse exchanges are typically more expensive to complete than other 1031 exchanges because they require additional third-party service providers (EAT, qualified intermediary and attorneys), additional documentation fees, including but not limited to deed recording fees, escrow and title fees, lender charges and entity formation for single-purpose entity to temporarily hold title of the replacement property. Undertaking a reverse exchange is a complicated process with numerous details and procedures that need to be completed in order to successfully defer the recognition of taxable gain. However, the upfront costs associated with this process can be a drop in the ocean compared to the tax liability that may result from not exercising a reverse exchange.