Business Law
Reverse Like Kind Exchanges

Overview

Section 1031 of the Internal Revenue Code provides an exception to the general rule that gain realized on a sale or exchange of property must be recognized. The exception applies where real estate held for business or investment (not personal use) is exchanged for “like-kind” property also held for business or investment. 

Intangible assets such as stock or partnership interests do not qualify. A critical requirement is that the taxpayer must not have actual or constructive receipt of sale proceeds (i.e., don’t touch the cash).

Expanded Opportunities

Sales among controlled entities (“incestuous” sales) qualify and can create opportunities to “switch basis” between properties held in different taxpayer-controlled entities.

Deferred Exchanges

A deferred like-kind exchange allows taxpayers to avoid taxation through an IRS safe harbor. Here’s how it works:

1. Proceeds of the original sale are placed in escrow.
2. Escrowed funds are used to buy the replacement property.
3. The replacement property must be identified within 45 days of the sale.
4. The closing on the replacement property must occur within 180 days.
5. A qualified intermediary is used as a “straw man” to handle the closings.

Done properly, the exchange has no effect on how the closings are conducted but successfully avoids recognizing taxable gain.

Reverse Exchanges

In September 2000, the IRS created a safe harbor for reverse exchanges. In these cases:

• A qualified intermediary acquires the replacement property using the taxpayer’s money or credit.
• The taxpayer has 45 days to identify the property to be sold.
• The taxpayer has 180 days to close on the sale of that identified property.

This safe harbor eliminates many technical risks and allows taxpayers to engage in build-to-suit transactions with pre-tax money.

Example

Suppose a developer wants to acquire a lot, build an apartment building, and sell appreciated real estate. The process could work as follows:

1. The developer’s intermediary forms Newco to acquire the lot and build the apartment building using the developer’s funds/credit.
2. Within 45 days after Newco takes title, the developer identifies the property to be sold.
3. Within 180 days, the developer sells the identified property and uses the proceeds to acquire the lot and apartment building from the intermediary.

The result: no taxes are paid on the appreciated property sale. The developer receives the lot and building with a tax basis equal to its cost, reduced by the gain deferred under the exchange.
Note: A 2005 Revenue Procedure restricts similar transactions if related parties are involved.