In a reverse exchange, the replacement property is purchased before the relinquished property is sold.

Why do reverse exchanges take place?

·         The taxpayer may identify a replacement property before being able to find a buyer for the relinquished property.

·         The taxpayer may have intended to sell the relinquished property before buying the replacement property but has run into problems with the transfer of the relinquished property.

·         This could be a very practical approach when relinquishing multiple properties.

The Internal Revenue Service (IRS), on 15 September 2000, issued a guidance that gave official sanction to 1031 reverse exchanges. The guidance, also known as safe-harbor guidance, provides for the following for a 1031 reverse exchange to be so recognized by the IRS:

·         Title to the replacement property should be held by a Qualified Intermediary (QI) or another legal entity controlled by the QI.

·         The QI cannot be the taxpayer or a disqualified person. A disqualified person includes accountants, attorneys and realtors who have rendered professional services to the taxpayer within two years prior to the exchange transaction.

·         The taxpayer and the QI must enter into a written “Qualified Exchange Accommodation Agreement”. This agreement must be entered into 5 days from the date the QI takes title to the replacement property.

·         The taxpayer must identify the relinquished property within 45 days of the purchase of the replacement Property.

·         The relinquished property must be sold within 180 days of the purchase of the replacement property. The replacement property should also be transferred to taxpayer within the said 180 days. Effectively, a 1031 reverse exchange transaction should be completed within 180 from the date of purchase of the replacement property.

·         If the transaction is not completed within the aforesaid 180 days, it falls outside the ambit of the guidance in which case the transaction will stand or fall on its own merits. In such a situation, the transaction runs a high level of audit risk by the IRS. It should be noted that the guidance is optional, not mandatory.

·         Even if the transaction is not completed within 180 days, the taxpayer can choose to discontinue his or her attempt to obtain a reverse exchange and take title to the purchased property.

·         The taxpayer can act as a construction manager for making improvements to the replacement property during the period the property is held by the QI.

·         The taxpayer can lease the replacement property from the QI until it is transferred to him or her.

·         The QI must report the transaction to the IRS. Specifically, the QI is required to attribute the “tax attributes” of the property since he or she is effectively the owner of the property until it is transferred to the taxpayer.

·         The taxpayer can indemnify the QI against loss. 

·         The taxpayer can loan or advance funds to the QI to purchase the replacement property. If a lender is involved in the purchase of the replacement property, it is important that the lender be informed at the earliest stage of the transaction that it is an exchange transaction.