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Topic 6 - Reverse Exchanges

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A reverse exchange is a transaction in which the Replacement Property is acquired before the Relinquished Property is sold. This powerful tax planning procedure permits you to acquire the Replacement Property currently under favorable circumstances before you are able to sell the Relinquished Property.

If the Relinquished Property is sold before the Replacement Property is acquired, you follow the safe harbor rules of Reg 1.1031(k)-1 and transact a normal or forward exchange. However, if you are unable to dispose of your Relinquished Property first, it is still possible to qualify for the desired tax treatment of §1031 by following the safe harbor rules of Rev. Proc. 2000-37.

There are many situations where the reverse exchange can solve exchange dilemmas. These are especially important in depressed real estate markets. Here are three examples:

You must close on the Replacement Property or lose your earnest money deposit.

You have not found a buyer for the Relinquished Property.

Your financing commitment at good rates will expire if you don't buy the Replacement Property before you can close on the sale of the Relinquished Property.

Real estate exchanges under §1031 deferred exchange rules generally do not permit you to buy the Replacement Property until after you have sold your Relinquished Property. But many times you find it necessary or desirable to acquire the Replacement Property first. Since buying the Replacement Property first requires a “parking arrangement”, Revenue Procedure 2000-37 actually deals with “parking transactions.” The “parking” can take place with either the Relinquished Property or the Replacement Property.

The biggest difference in the rules for reverse exchanges involves the time restrictions. Under the normal or forward exchange rules, the Identification Time Period and Exchange Time Period both start on the day the Relinquished Property is surrendered. Not so with a reverse exchange.

The reverse exchange rules require the entire reverse exchange to be completed within 180 days of the date your Qualified Intermediary acquires the Replacement Property for you.

âCaution: Reverse exchanges are very complicated and usually incur considerable costs including legal and additional Qualified Intermediary fees. A careful analysis of the exchange and the amount of income tax saved should be made and compared to the total costs. Many times the tax saved is not enough to justify the added costs.