Reverse Exchange: What It Is, How It Works, and Examples

A reverse exchange in real estate is a unique property transaction method where the replacement property is purchased before the sale of the current property. Unlike traditional exchanges, it allows investors to secure a new property first, affording flexibility in timing the sale of their existing property to optimize profit.

In a reverse exchange, the standard rules of like-kind exchanges may not directly apply. Typically, investors can defer capital gains taxes on a property sale by reinvesting the profits into a “like-kind” property. However, the IRS has established safe-harbor rules allowing for like-kind treatment, particularly if the properties are held in a qualified exchange accommodation arrangement (QEAA).

Success in a reverse exchange depends on an investor’s financial readiness to fund the new property without having completed the sale of the old one. Securing appropriate funding or working with specialized lenders is crucial in this process. The investor must meet financial obligations without the proceeds from the relinquished property’s sale.

Reverse exchanges, governed by Section 1031 of the Internal Revenue Code, pertain to real property held for investment or business purposes. There are strict timelines—an investor has 45 days to identify potential replacement property and 180 days to finalize the purchase, or taxes will apply.

The IRS has clarified reverse exchange rules through Revenue Procedure 2000-37, offering guidelines for property owners undertaking such transactions. Despite this, confusion remained, leading to a Tax Court ruling in 2017 (Estate of Bartell, 147 T.C. No. 5, 2016) challenging the IRS’s stance on the responsibilities of exchange facilitators in a valid 1031 reverse exchange.

In a reverse exchange, the replacement property is acquired before the sale of the current property, allowing flexibility in timing the sale for optimal profit. In contrast, a delayed exchange involves first selling or trading the current property before acquiring a new one.

Not every property is eligible. Section 1245 or 1250 properties are ineligible for this transaction. Reverse exchanges primarily apply to Section 1031 properties, typically investment or business-related.