In a typical tax deferred exchange, the taxpayer sells the relinquished property and either contemporaneously or later acquires the replacement property. This process is reversed in what is called a “reverse exchange.” In this permutation of the exchange process, the replacement property is purchased before the relinquished property is sold. In the typical reverse exchange, the taxpayer identifies the replacement property and obtains the agreement of a third party, called an “exchange accommodation titleholder,” to take title to the replacement property on the taxpayer’s behalf before the taxpayer sells the relinquished property.
A taxpayer may want to use a reverse 1031 exchange for several reasons: (1) the taxpayer has not yet found a buyer for the property to be relinquished; (2) the taxpayer must close on the replacement property by a certain date to obtain favorable financing or avoid forfeiting a deposit; or (3) improvements need to be made on the replacement property.
The IRS has published procedures that provide what is called a “safe harbor” in a reverse exchange. Compliance with this safe harbor provides assurance to the taxpayer that the characterization of the properties involved in the transaction, and their interim ownership by the titleholder, will be deemed in compliance with IRC Section 1031. An exchange that does not comply with the safe harbor rules may or may not qualify for tax-deferred treatment.
The safe harbor is satisfied if an “accommodation arrangement” is made pursuant to which the following requirements are met (note: these are an abbreviated version of the most relevant requirements):
- Title to both the replacement and the relinquished properties are held by an independent qualified accommodator.
- The taxpayer has a bona fide intent that the property so held is either replacement or relinquished property that is intended to qualify for tax deferment.
- No later than 5 days after the accommodator takes title to the replacement property, the accommodator and the taxpayer enter into a written agreement that provides that the accommodator is holding title to the replacement property for the benefit of the taxpayer in furtherance of a section 1031 tax-deferred exchange.
- No later than 45 days after title to the replacement property is transferred to the accommodator, the taxpayer identifies the property to be relinquished.
- No later than 180 days after title to the replacement property is transferred to the accommodator, the title is transferred again, this time to the taxpayer.
- A final step also contemplated is that the relinquished property is transferred to the taxpayer’s buyer.
The regulations and procedures prescribed by the IRS for reverse exchanges are complex and reason to employ the services of a Texas property exchange expert in any such transaction. If you are planning to sell and acquire investment property, contact the experienced experts at Brazos 1031 Exchange Company, LLC.