A Reverse Exchange Primer

For the first time in a couple of years, we’re starting to get more calls about reverse exchanges.  To me, this is a positive indicator that things are slowly starting to get better in the real estate industry. It means that buyers are actually confident enough that we’ve hit bottom, and they’re willing to go on the hook to purchase new property when they still haven’t sold their old property.

Since it’s a hot topic again, and since there are several different types of reverse exchanges, now is a good time to do a quick primer on what reverse exchanges are, how they work and what options are available to you, the investor.  

A basic starting place is that in a 1031 exchange, the IRS will not let you take title to your new property while you still hold title to your old property.  This makes sense because if it weren’t so, people would claim the property they bought five years ago is replacement property for one they just sold.  Realizing, however, that there are legitimate reasons to buy a new property first in a 1031 exchange, the IRS has issued guidance on structuring reverse exchanges. Essentially what happens in a reverse exchange is your 1031 intermediary takes title to one of the properties (typically the new one) and holds it until your old property sells.

In order to document that a new property is part of an exchange, the IRS requires that your intermediary set up an entity that takes title to the new property until the close of your old property. 1031 law gives your intermediary broad powers to act on your behalf, so they won’t allow someone other than your intermediary to handle this role.  To summarize the basic structure: you hold title to one of the properties and your intermediary holds title to the other until your old property sale is complete.

Safe Harbor Reverse Exchanges:  The IRS specifically blesses what is typically called a “safe harbor” reverse exchange. If the intermediary structures the exchange a certain way and you complete the sale of your old property within 180 days from when the intermediary takes title to the property, the IRS automatically blesses your reverse exchange. And though they will not audit your exchange, they may still look at parts of it to make sure that you meet the safe harbor requirements.  Many 1031 intermediaries do safe harbor reverse exchanges, but because of the administrative costs they are not cheap.

Non-Safe Harbor Reverse Exchanges:  The IRS acknowledges that not every reverse exchange can be completed within the 180 days. While non-safe harbor exchanges are not disallowed, they don’t receive the same blessings that safe harbor transactions do.  In other words, the IRS doesn’t automatically disallow them, but may look at them more in-depth than a safe harbor transaction.

The documentation is different for safe vs. non-safe reverse exchange, so you’ll have to decide before the documents are drafted which way you may want to go. Safe is, well, ‘safe;’ more reliable but with fewer options. Non-safe has more flexibility, but incurs additional challenges. Very few intermediaries will do non-safe reverse exchanges, and they are more expensive than safe harbor reverses.

Construction Exchanges:  You can buy a piece of bare land and build a building on it to qualify as the replacement property for the sale of your old property.  While it’s theoretically possible to sell your old property, buy the bare land and spend enough on construction to satisfy the exchange requirements within 180 days of the sale of your old property, it’s very difficult anywhere in the United States to get the necessary permits and approvals to do any significant construction within that time. If it’s nailed to something attached to the dirt: it’s real estate. If it’s a pallet of lumber sitting on the dirt, it isn't; and therefore it's not exchangeable.

Since 1031 rules say that once you take title to a property your exchange is complete, virtually all construction exchanges involve some form of reverse exchange. Your intermediary will, in this case, take title to the bare land and do the construction for you.  And since all construction takes time (large projects can take 3 or 4 years or more), almost any construction exchange will involve a non-safe harbor transaction. This means your pool of possible 1031 intermediaries will be very small.

Improvement Exchanges: You can buy an existing property with part of your exchange proceeds and use the balance of the funds to make improvements to it.  Like construction exchanges, once you take title in your name, the exchange is complete on that property. So again, these types of transactions are structured as reverse exchanges with the intermediary taking title until the improvements are complete.  Unlike construction exchanges, however, most improvements are completed within the 180-day timeframe, so these tend to be safe-harbor type transactions. Most intermediaries that do reverse exchanges can handle these for you. 

One pitfall to be aware of is that oftentimes a real estate investor starts out doing a straight exchange and then finds a fixer-upper, or doesn’t communicate their intention to do an improvement exchange with the intermediary. Then and only then does he find out his intermediary does not do reverse exchanges at all. The result is that either his exchange fails or a large part of it is taxable.  If there is ANY possibility of you doing a construction or improvement exchange, make sure you communicate that to the intermediary before you retain them. Make sure they have the ability and expertise to handle your exchange.