What is a “Reverse” 1031 Exchange?

A 1031 exchange is a valuable tax shelter when you sell investment or business property. Instead of just selling, you take the money you had invested in your Old Property and reinvest in a New Property ("exchanging" the Old for the New) through a Qualified Intermediary (or Q.I.), following I.R.S. guidelines.

Pay attention to the term "New." To complete a 1031 exchange that will qualify under the rules, you have to acquire a property that is new to you -- meaning, you can't apply your sale proceeds to a property you already own, or even a property that you have owned any time in the past 18 months. This means you can't have an exchange if you ever own the Old and New Properties simultaneously.

So what happens if you need to buy New Property before you have sold your Old Property? You can still defer capital gains with a "reverse exchange." In simple terms, in a reverse exchange, your Q.I. arranges to take title to the New Property, and "park" it, until you can close on the sale of your Old Property. You then complete the exchange by acquiring the New Property from the Q.I.

The I.R.S. has approved the reverse exchange structure, but the rules are much more complex. While a reverse exchange may allow you great flexibility to grab a hot property before it is off the market, to incorporate construction or repair work into an exchange, it is also easy to ruin a reverse exchange with bad advice or planning. It is critical to work with a Q.I. that is very experienced with them.

Is there a catch? Actually, there are two speed bumps to overcome in a typical reverse exchange. First, financing the purchase of the New Property is more difficult. While your Q.I. can arrange to buy the property, you will still have to arrange for the money to do so... and since you don't have any proceeds from your Old Property yet, you may need to borrow the money. There are lenders who will work with this process, but you will need to find a bank or "portfolio" lender rather than a traditional mortgage lender. Second, the exchange will be more expensive. The complications of a reverse will add to the fees charged by your Q.I., your lender, and your title company -- but usually even these higher fees are peanuts compared to the tax savings you can accomplish.