Reverse 1031 exchanges can provide flexibility for investors.
Though reverse 1031 exchanges are becoming more common in the real estate community -- particularly in an economic environment in which investment opportunities abound for those who are fiscally able -- many property owners remain uncertain of when a reverse 1031 exchange is appropriate and ensure that an exchange adheres to IRS revenue procedure 2000-37. Following this procedure makes sure that the reverse exchange transaction retains its "safe harbor" designation. When the IRS refers to safe harbor, it is essentially saying that it will not interfere with the transaction during this safe harbor period. Also, this ensures that the tax advantages (deferral of applicable capital gains from the original property sale) are retained.
Instructions
1. Determine the type of reverse 1031 exchange is appropriate for your proposed transaction. While the most common is the safe harbor reverse 1031 exchange, there are also traditional reverse exchanges for those transactions that cannot meet the safe harbor regulations (the entire transaction must be complete within 180 days), construction exchanges where real property is part of the transaction (again, these are usually not able to meet safe harbor guidelines) and other even more complex and less used exchanges.
2. Select the real estate you want to purchase and arrange for the funding source. Since the reverse 1031 exchange allows an investor to purchase a property prior to the sale of an existing home or building, the exchange provides for quick movement on property of interest rather than having to wait until the sale of the existing property. However, with the time limits involved to retain the blessing of the IRS, knowing the property and having the funding in place (since there will be no proceeds from the sale of the existing property) beforehand are critical.
3. Develop a Qualified Exchange Accommodation Agreement, which entails an Exchange Accommodation Title (often in the form of an LLC) to "hold" the new property. This is required because the IRS does not allow ownership of both properties simultaneously and still retain safe harbor qualification. So, technically, the EAT is the owner of the acquired property. After the property is transferred to the EAT, you have five days to develop a written QEAA.
4. Qualifying for safe harbor protection as part of the reverse 1031 exchange also requires naming, or providing the specifics of, the property to be sold (the original property) as part of the QEAA within 45 days. Again, timing is crucial to avoid potential IRS audits questioning whether the transaction qualified for safe harbor protection.
5. Complete the entire reverse 1031 transaction within the aforementioned 180 days. If for some reason this is not possible (the original property does not sell in time, for example), it does not mean an automatic IRS audit. However, it does mean that an IRS review remains a possibility and that it is likely the transaction is no longer protected from capital gains taxes from the original property sale, if applicable.
