Most savvy real estate investors are very familiar with the 1031 (tax-deferred) exchanges. This exchange allows them to defer capital gains tax when they sell a property as long as they use the proceeds to acquire a similar property within a certain period. However, what many of them fail to realize is that there is an alternative route that gives them extra control in the real estate market – a reverse 1031 exchange.
A reverse 1031 exchange is also a tax-deferred exchange method that offers a wide range of potential benefits. However, this exchange is more complex than a forward 1031 exchange and requires a more careful approach and planning. Here is detailed information about the reverse 1031 exchange.
What Is a Reverse 1031 Exchange?
As the name implies, a reverse 1031 exchange is the opposite of a forward (delayed) 1031 exchange. In reverse exchange real estate, you acquire the replacement property first before selling the current property you want to relinquish.
Nonetheless, you can’t take actual possession of the new property until you have completed the whole 1031 transaction. Instead, your Exchange Accommodation Titleholder (EAT) will hold the replacement property until you have sold the old property.
Why Do Savvy Investors Do a Reverse 1031 Exchange?
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The times are changing, and this change is accompanied by many real estate investing opportunities. When you do a reverse 1031 exchange, you stand to gain the following potential opportunities:
- The chance to seize the majority of potential opportunities before other real estate investors get a shot at them
- An opportunity to lock in properties at the right time for the right price in this ever-changing real estate market
- More time to choose and negotiate the best deal that matches your investment strategy for the property you want to relinquish since you’d have bought the replacement property first
- Listing your relinquished property for sale after locking in your replacement property gives you better control over the price and contract terms. This means you can hold your property until its market value increases, as long as it is within the reverse 1031 exchange timeline
The Requirements for a Reverse 1031 Exchange
Before you can make a reverse 1031 exchange, you must meet the following requirements:
Since you’ve not sold your relinquished property yet, you’ll need to gather the funds to pay for the replacement property. To do this, you can access traditional financing for asset acquisition.
As an investor trying to do a reverse 1031 exchange, you can’t hold the titles to both properties simultaneously. This is where parking comes in. Parking means the title and possession of one of the properties being transferred to the EAT until the exchange is completed.
- A Good Timing
The reverse 1031 exchange has a life span in which all activities concerning the exchange should have been completed. Usually, it is 180 days after the procurement of a property. After this period, your exchange no longer qualifies as a reverse 1031 exchange or any 1031 exchange and hence will be subjected to taxable events on capital gains.
What are the Rules for Reverse 1031 Exchange?
The reverse 1031 exchange rules are the same as that of the forward 1031 exchange. Endeavor to know these rules before acquiring a replacement property and, of course, selling the relinquished property. The rules are:
- After the initial closing, all reverse exchanges must be completed within 180 calendar days
- Both the party buying and the party selling must have the same taxpayer
- The rules regarding related parties and disqualified persons are very much valid
- The value for the replacement property must either be greater or equal to that of the relinquished property. Should it be lesser, payable tax is triggered on the difference
- Neither of the properties in a reverse exchange can be the primary residence of the taxpayer. Both properties are to be used solely for investment or trade purposes
- Provided that both properties concerned exist in a qualified exchange accommodation agreement, reverse 1031 safe harbor rules permit like-kind treatment
Reverse 1031 Exchange Time Periods
Both the reverse and forward 1031 exchanges share the same timelines, as well as other types of 1031 exchanges. Generally, an exchange is only agreed to have been made when one property has been swapped for another.
However, it may not be easy to locate the exact property you want. Putting all these into consideration, the IRS allows only two timelines and they are:
- 45 Days
Once you close in on the purchase of the replacement property, you have to notify your intermediary of your relinquished property within 45 days.
- 180 Days
You must do all closing on the sales of your replacement property within 180 days of the closing of the purchase of your replacement property.
Structure of a Reverse 1031 Exchange
Depending on your specific needs, you can structure a reverse 1031 exchange in California in any of the two ways. They are:
- Exchange First Reverse 1031 Exchange
In this structure of reverse 1031 exchange, the EAT takes the title of relinquished property before you purchase the replacement. Then you provide funds for the EAT to purchase the relinquished property; the price for the property is estimated by fair market value.
Afterward, you’ll sign a Qualified Exchange Accommodation Agreement (QEAA) and lease to allow you to maintain control over the property. You then locate and purchase replacement property and the EAT is made to take the title and possession of the property.
You must also close the sale of the relinquished property within 180 days of the EAT taking its title. The proceeds from this sale will then be given to you by the EAT as reimbursement of the funds you provided them with initially to purchase your relinquished property.
However note that if your relinquished property was sold higher than the estimated fair market value which the EAT purchased the property for, you’d have to pay capital gain tax on the difference.
- Exchange Last Reverse 1031 Exchange
In this case, you give the EAT the title and possession of the replacement property as soon as you close on its purchase. You also provide the EAT the funds to make the purchase and if there’s any form of financing, the EAT is named the borrower.
Afterward, a Qualified Intermediary (QI) sells the relinquished property on your behalf within 180 days. Then, the proceeds from the sales are then used to buy the replacement property from the EAT. The EAT in turn transfers the title of the replacement property to you and uses the funds received to pay off any existing debt incurred in the purchase of the replacement property.
How to Carry Out a Reverse 1031 Exchange
To do a reverse 1031 exchange, you have to follow the following steps:
- Scout and identify a property you want to use as a replacement for your old property. Then source for the funds to pay for the property. You can provide cash, short-term private money, or any conventional financing
- Since you are not allowed to take titles of both properties at the same time, execute an agreement with your EAT. Your EAT will then take title and possession of your replacement property until the sale of your relinquished property is closed
- Close on the purchase of your replacement property after which the EAT will be given the title and possession
- From the date of the successful closing of the purchase of your new property, you have only 45 calendar days to make the identity of the property to be sold known
- Enter a written agreement with a buyer for your old property. However, make sure that neither you nor the Limited Liability Company (LLC) you’re holding the property under is named as the seller of the property. Rather, the EAT should be named as the seller
- Employ the services of a Qualified Intermediary (QI), with whom you’ll need to enter an agreement. The agreement should give the QI the right to transfer the relinquished property’s title to the buyer. This agreement should also give the buyer the right to take the title of the property from the EAT upon closing on the purchase of the replacement property
- Then, make sure you close the sale of the relinquished property within 180 days of the successful completion of the purchase of your new property. Within this time, you must also ensure you the following things are done:
- Give the relinquished property to the buyer through a deed
- Proceeds from the sales of the relinquished property are transferred to the QI directly
- Then, using the proceeds from the sale of the old property, the QI acquires the replacement property from the EAT
- Finally, the reverse 1031 replacement property is completed when the title and possession of the replacement property are transferred to you
There you have it – the essential things you need to know about a reverse 1031 exchange. As an investor, this method is a valuable weapon in your arsenal. It allows you to buy a replacement property before selling the one you’re planning to relinquish.
However, this strategy can be quite complex at times. If you aren’t careful, you can incur additional expenses. This is why you need to speak with a professional to guide you every step of the way.