Navigating Insurance Coverage Requirements in Reverse 1031 Exchanges

When structuring a reverse 1031 exchange, real estate investors often focus on tax deferral mechanics—but there’s another crucial component that can’t be overlooked: insurance coverage. Reverse exchanges typically involve Special Purpose Entities (SPEs) and third-party titleholding arrangements, which introduce complex risk exposure. Ensuring the correct insurance coverage is in place not only protects the investment but also preserves the integrity of the exchange.

Here’s a breakdown of the insurance considerations investors should be aware of during a reverse exchange.

Special Purpose Entity Formation and Its Implications

Most reverse 1031 exchanges involve forming a Special Purpose Entity (SPE)—commonly an LLC—to serve as the Exchange Accommodation Titleholder (EAT). This entity temporarily holds title to the replacement property until the relinquished property is sold.

The use of an SPE isolates risk and limits liability. However, it also complicates insurance coverage because the legal owner of the property is not the investor, but the SPE. This can affect who holds an insurable interest and how insurance policies are structured.

Insurable Interest: Who Needs Coverage?

An insurable interest exists when a party stands to suffer a direct financial loss from damage to the property. In a reverse exchange, both the SPE/EAT and the investor may have an insurable interest:

• The SPE, as legal titleholder, needs coverage for its ownership interest.

• The investor, as the beneficial owner, has a vested interest in protecting the value of the property and any improvements made during the exchange period.

It’s critical that all entities with insurable interests are named properly in insurance documents to avoid denied claims or compliance issues.

Required Insurance Coverage in Reverse Exchanges

The type and amount of insurance coverage required will depend on several factors, including whether the property is under construction, leased, or vacant during the exchange period. At a minimum, policies must cover:

Liability Insurance

Liability coverage protects against third-party claims for bodily injury or property damage. Because the SPE holds legal title, general liability insurance should be secured in its name—with the investor named as an additional insured.

Property and Casualty Insurance

This policy protects against physical damage to the real estate from events like fire, storm, or vandalism. The SPE should carry property insurance that names the investor and any lenders as additional insureds or loss payees to ensure the appropriate parties are protected.

Course of Construction Insurance (Builder’s Risk)

If improvements or construction are being made on the replacement property before the exchange is completed, a course of construction insurance policy (also known as builder’s risk insurance) is essential. This policy covers:

• Damage to the building while under construction

• Materials, equipment, and supplies on-site

• Costs associated with delays or reconstruction

Both the SPE and the contractor should be named on the policy, with the investor included as an additional insured.

Workers Compensation Insurance

If construction or renovation is underway, ensure that any contractors or subcontractors carry workers compensation insurance. Without this, injury claims could flow back to the SPE or the investor, especially if independent contractors are incorrectly classified.

As a safeguard, request certificates of insurance from all vendors and confirm compliance with state workers comp laws.

Primary vs. Excess Insurance Coverage

Depending on the value and complexity of the property, you may need both primary and excess (umbrella) insurance policies:

• Primary insurance covers the initial layer of risk up to policy limits.

• Excess coverage provides additional protection beyond those limits.

In reverse exchanges involving high-value commercial properties or development projects, layering coverage ensures adequate protection in the event of catastrophic loss or litigation.

Insurance is a foundational part of executing a reverse 1031 exchange correctly and securely. Investors must work closely with their Qualified Intermediary, legal counsel, and insurance advisors to:

• Establish the right entity structure

• Identify all parties with an insurable interest

• Ensure proper coverage is in place before closing

Failing to address insurance requirements can leave gaps that jeopardize both the property and the tax deferral.

Before you enter a reverse exchange, ask: Are all risk factors covered—and are the right parties protected? If not, the exchange could come at a greater cost than intended.