Reverse 1031 Exchanges: How to Buy Before You Sell

In a standard 1031 exchange you sell first and buy second. A reverse exchange flips the order: you buy the replacement property before your current property sells. It is the right tool when the property you want won't wait, but it has its own rules, costs and financing hurdles, and it has to be set up before you close on the purchase.

Why would you buy first?

Most reverse exchanges start with one of three situations:

• The right property came up early. You found a replacement you don't want to lose, and your current property isn't listed or under contract yet.
• Your sale is delayed. The buyer of your property needs more time, but your replacement purchase has a fixed closing date.
• The market is tight. In competitive markets, sellers favor buyers who can close without a sale contingency.

The problem is that you can't simply buy the replacement in your own name and exchange into it later. The tax code treats an exchange as trading property you own for property you don't yet own. If you already hold title to both, there is nothing left to exchange.

How a reverse exchange works

The solution is to have someone else hold title temporarily. An exchange accommodation titleholder (EAT), usually a single-purpose company set up by the intermediary, takes title to one of the properties and "parks" it until your sale closes. The IRS created a safe harbor for these arrangements in Revenue Procedure 2000-37, later modified by Revenue Procedure 2004-51. If you follow it, the IRS will not challenge the parking arrangement.

The safe harbor has strict requirements:

1. A written agreement within five business days. You and the EAT must sign a qualified exchange accommodation agreement no later than five business days after the EAT takes title. In practice, it is signed before the purchase closes.
2. Identify the property you'll sell within 45 days. Within 45 days after the EAT takes title, you must identify in writing the property (or properties) you plan to sell, using the same identification rules as a standard exchange.
3. Finish within 180 days. Within 180 days after the EAT takes title, your old property must be sold and the parked property transferred to you. The EAT cannot hold the property for more than 180 days in total.
4. An independent titleholder. The EAT can't be you or a disqualified person, such as your agent, attorney, accountant or broker in the past two years, and it must be subject to federal income tax.

One more limit comes from Revenue Procedure 2004-51: the safe harbor does not apply to replacement property you owned at any time in the 180 days before the EAT acquired it. You can't park property you already own and then "buy it back" as your replacement.

Exchange last or exchange first

There are two ways to structure a reverse exchange, depending on which property the EAT holds.

Exchange last (the common structure)

The EAT buys and holds the replacement property. When your old property sells, the sale proceeds go to your qualified intermediary, which uses them to pay for the replacement. The EAT then transfers the replacement property to you, and the exchange is complete. This is the structure most investors use.

Exchange first

You take title to the replacement property right away, and the EAT takes title to your old property until a buyer is found. This can help when a lender insists on lending to you directly, but it requires funding the EAT's acquisition of your old property, so it is used less often.

Paying for the property before you sell

Because your sale proceeds aren't available yet, you need another source of funds for the replacement purchase. That usually means some combination of:

• Your own cash, advanced to the EAT as a loan.
• A loan from a bank to the EAT's single-purpose company, typically with your personal guarantee.
• A line of credit or bridge loan you arrange and lend through to the EAT.

Financing is the most common obstacle. Some lenders are unfamiliar with lending to an accommodation titleholder, so involve your lender early and give them the structure in writing. When your old property sells, the proceeds repay the funds you advanced or reduce the loan, as the exchange documents provide.

What makes reverse exchanges harder

• Two tight clocks start at purchase, not sale. Your 45 and 180 days begin when the EAT takes title. If your old property doesn't sell in time, the exchange fails.
• Higher costs. Expect fees for forming the single-purpose company, holding title and additional closing documents. Ask about transfer taxes in your state, since how title is held can affect them.
• More coordination. Your lender, title company, attorney, CPA and intermediary all need to agree on the structure before closing.

Arrangements that run past 180 days or otherwise fall outside the safe harbor are possible, but they carry real audit risk and need careful legal advice.

Reverse exchanges with improvements

A reverse exchange can be combined with construction. While the EAT holds the replacement property, it can build improvements using funds you provide, so that the improvements count toward the value of your replacement property. Only work completed before the EAT transfers the property to you counts, and the 180-day limit still applies. See our guide to improvement exchanges.

Is a reverse exchange right for you?

A reverse exchange makes sense when the replacement property matters more to you than the extra cost and complexity, and when you're confident your current property can sell within 180 days. If your sale is already under contract and closing soon, a standard forward exchange is simpler and cheaper.

The decision has to be made before you close on the purchase. Once you take title to the replacement property in your own name without a reverse exchange in place, it is too late to set one up. (In the exchange-first structure, the titleholder must take your old property at or before your purchase closes.) If you are considering one, talk to us early, and see our reverse exchange service for how we handle the titleholder, documents and deadlines.