“I’m out of luck with the taxes,” my investor friend told me. “I bought another rental home before selling the first.”

Most real estate investors in Texas are aware that you can defer capital-gains tax by selling one investment property and then buying another investment property of equal or greater value within certain timeframes.

That process, known as a Section 1031 Exchange, or a Starker Exchange, was helped along five years ago with adoption of Revenue Procedure 2000-37, giving the green light to “reverse exchanges.” Those guidelines, which went into effect Sept. 15, 2000, permit the title to the “new” property to be held by an independent third party (typically a facilitator or attorney) until the “old” property sale closes. Relatively few investors, however, have utilized a reverse exchange.

While the reverse exchange can sometimes be a more costly and difficult method, it also can be a cash saver. If you follow all of its requirements, you should be in the clear. If you fail to meet all of the procedures, your exchange may still be successful, but will be subject to second-guessing by the Internal Revenue Service in the event of an audit.

In capsule, Revenue Procedure 2000-37 came late to the party. The basic Code Section 1031 will not let a taxpayer buy the replacement property, or new property, until after he or she has sold the old, or relinquished, property. Nonetheless, taxpayers had fallen into situations beyond their control where they needed to take title to the new property before the sale of the old property closes.

For example, someone in Dallas is scheduled to close the sale of his or her old property on Wednesday and the purchase of his new property on Friday. On Tuesday, he learns that the buyer of his old property must delay the purchase for a couple of weeks because the buyer’s lender needs an additional appraisal completed before it will fund the loan. The seller of the new property demands that the buyers close on Friday, as the two parties agreed, or the seller will sell the property to someone else and keep the earnest money.

In this situation, the buyer's best alternative is to do a reverse exchange and have their qualified intermediary (or exchange facilitator) take title to the new property and hold, or “park” it, until the old property closes. Then, the intermediary transfers the new property to the seller to complete the exchange. These parking arrangements are the main ingredients of the reverse exchange procedure.

“The guidelines really provide a safety valve for those consumers already doing conventional exchanges,” said Richard Morse, president of Bellevue-based Washington Exchange Services. “This way, they can tie up the new property even if they don’t have a buyer for the old property.”

The initial IRS regulations for 1031 Exchanges, issued nearly 15 years ago, specifically excluded reverse exchanges. However, some consumers had gambled for years and structured reverse exchanges anyway, much to the chagrin of accountants and attorneys who warn of a possible audit. The reverse procedure provides the same safe harbor protection for reverse exchanges that delayed exchanges enjoy, but sometimes funds are tough to secure without the sale of the first property.

“The reverse rule also brought some challenges for buyers and sellers,” said Rob Keasel, Certified Public Accountant in the accounting firm of Anderson Zurmuehlen & Co. “For example, if the buyer does not have funds elsewhere to pay cash, will lenders actually finance properties for the buyer when a facilitator holds title to that property?”

Often lenders have extended funds for a specific period of time to the facilitator – as long as the loan is secured by the person making the exchange.

Section 1031 specifically requires that an exchange take place. That means that one property must be exchanged for another property, rather than sold for cash. The exchange is what distinguishes a Section 1031 tax-deferred transaction from a sale and purchase. The exchange is created by using an intermediary (or exchange facilitator) and the required exchange documentation.

Also, never underestimate Uncle Sam’s desire to have you hire a professional third party to oversee reverse or delayed-exchange transactions. If you attempt an exchange on your own and it fails, the consequences could be drastic.