What to Know Before Opening a Reverse 1031 Exchange

Most real estate investors are familiar with the standard 1031 exchange: sell a property, then reinvest the proceeds into a new like-kind property to defer capital gains tax. But in competitive markets, you might find the perfect replacement property before your current property is ready to sell. That’s where a reverse 1031 exchange comes into play.

A reverse exchange lets you acquire the replacement property first and then sell your relinquished property later—without giving up the tax deferral benefits. However, this structure is more complex and must be executed carefully to comply with IRS guidelines. If you’re considering a reverse 1031 exchange, here’s what you need to know before you get started.

The Structure Behind a Reverse Exchange

Unlike a forward exchange, you can’t hold both the relinquished and replacement properties in your name at the same time. That would disqualify the transaction from 1031 treatment. To work around this, the IRS allows the use of a third-party entity—called an Exchange Accommodation Titleholder (EAT)—to temporarily hold title to one of the properties during the exchange.

This process is governed by IRS Revenue Procedure 2000-37, which outlines the “safe harbor” reverse exchange structure. The EAT is typically a single-member LLC created by your Qualified Intermediary (QI), who facilitates the exchange process.

Laying the Groundwork: Engage a Qualified Intermediary Early

One of the most important requirements for opening a reverse exchange is engaging a Qualified Intermediary before the replacement property is acquired. The QI will help you structure the transaction, form the EAT, and ensure all documents comply with IRS rules. Without a QI in place before closing on the replacement property, the transaction could fail to qualify for tax deferral.

Holding Title Through the EAT

In a reverse exchange, the EAT takes legal title to either the replacement or relinquished property, depending on the chosen structure. In most cases, the EAT takes title to the replacement property. This is called a “parking arrangement,” where the EAT parks the property until the investor is able to sell the relinquished asset.

This arrangement is documented through a Qualified Exchange Accommodation Agreement (QEAA), which must be signed within five business days of the EAT acquiring the property.

Meeting the Timeline Requirements

Once the replacement property is acquired and held by the EAT, the reverse exchange clock begins. The IRS gives investors two critical deadlines:

• 45 days to identify the property you plan to sell (the relinquished property), and

• 180 days to complete the sale of the relinquished property and finalize the exchange.

These deadlines are fixed—no extensions—and failure to meet them means the transaction will no longer qualify for tax deferral.

Financing Considerations

One of the most challenging aspects of opening a reverse exchange is financing. Not all lenders are comfortable with this structure, especially when the EAT holds title. If you're planning to finance the acquisition of the replacement property, work with a lender who understands reverse exchanges and is willing to underwrite the deal under these terms.

In many cases, investors will loan funds directly to the EAT or structure financing with the lender through the EAT’s LLC.

Improvements and Customization During the Holding Period

One advantage of using a reverse exchange is the ability to improve the replacement property while it’s held by the EAT. This can be particularly useful in “build-to-suit” or “improvement exchange” scenarios. However, any improvements must be completed before the exchange is finalized and title is transferred to the investor.

Compliance and Risk Mitigation

Because reverse exchanges involve multiple moving parts—legal, financial, and logistical—it’s critical to work with a team that understands the nuances. In addition to a QI, you should consult with your tax advisor and a real estate attorney to ensure compliance with the latest IRS guidance.

While reverse exchanges fall under IRS safe harbor rules when properly structured, failing to follow the procedure precisely can trigger disqualification and unexpected tax liability.

Opening a reverse 1031 exchange is not something to improvise or rush into. It’s a powerful strategy for securing desirable investment property in a tight market, but it demands careful coordination and strict adherence to IRS guidelines. The earlier you involve your Qualified Intermediary and supporting team, the smoother your reverse exchange will be—and the better your chances of preserving your tax-deferral benefits.