How Do Reverse 1031 Exchanges Work? Why They’re Crucial for Deferring Capital Gains Taxes

Author: Anthony Alosi

Most of today’s real estate investors and agents are familiar with the traditional “forward” exchange: sell first, then buy. But this doesn’t account for desired replacement properties hitting the market before the successful sale of a current property. Today’s real estate market is cutthroat. Waiting to buy until after you’ve sold isn’t always realistic. 

That’s where reverse 1031 exchanges become powerful strategic options. Say you’re working with a client who needs flexibility to find new investment properties and defer their capital gains taxes.

So, how do reverse 1031 exchanges work? In this guide, we’ll cover everything you need to understand before entering the market.

How Do 1031 Exchanges Really Work?

A reverse 1031 exchange is a capital gains tax-deferral strategy that allows real estate investors to purchase a new property, often called a replacement property, before selling the relinquished property that they already own.

So, why does this matter for investors and real estate agents? Reverse 1031 exchanges offer a bit more flexibility to make an offer on a property of interest without waiting for the relinquished property to sell.

To answer how a reverse 1031 exchange works, it all starts with an Exchange Accommodation Titleholder (EAT). These are entities that step in to take title to the property while the taxpayer finds a buyer for their relinquished property.

How Many Types of Reverse 1031 Exchanges Can Investors Use?

There are two main types of reverse 1031 exchanges. Choosing between these options depends on several factors.

1. Exchange First

The first type of reverse 1031 exchange is where the relinquished property is parked with the EAT. Most commonly, the EAT takes title of the replacement property while the taxpayer works to sell the relinquished property. The EAT typically acquires the property using funds loaned or advanced by the taxpayer, and those funds are used to complete the purchase.

While the forward exchange is over quickly, the parking transaction of this reverse 1031 exchange may continue for the entire exchange period as the taxpayer locates a third-party buyer for the relinquished property within 180 days.

Once a third-party buyer is found for the relinquished property, the EAT transfers title to the buyer and applies any net sales proceeds to retire any debt, or portion thereof, incurred by the EAT on its acquisition of the replacement property. This can also include the loan from the taxpayer for the initial parking of the property.

Because Rev. Proc. 2000-37 does not require the taxpayer to use one or the other approach to achieve a nontaxable reverse exchange, the 'exchange first' concept can provide added flexibility to the process.

2. Exchange Last

In an ‘exchange last’ type of reverse 1031 exchange, the replacement property is parked with the EAT, which acquires title to the property and holds it until the taxpayer sells their relinquished property, completing the exchange. The acquisition is funded by a loan arranged by the taxpayer, who must then close on the relinquished property within 180 days. When the relinquished property is sold, the sales proceeds come to the qualified intermediary before the forward exchange. Then, EAT completes the exchange by directly transferring the deed to the replacement property to the taxpayer and providing the net proceeds from the sale to the taxpayer in repayment of their original loan.

This type of 1031 exchange provides the real estate investor with flexibility in cases where the taxpayer is either uncertain which of their properties will serve as the relinquished property, or when they don’t have cash to loan the EAT and need to obtain third-party financing for 100% of the purchase.

How Do You Perform Reverse 1031 Exchanges?

Almost every reverse 1031 exchange follows a similar process. Here are the steps you’ll need to take to determine how yours will work:

1. Find an EAT

Before you can start the reverse 1031 exchange process, identify a qualified exchange accommodation titleholder (EAT).

Your EAT should be a separate entity and completely unaffiliated with both the property buyer and the seller. This ensures fair treatment of the property throughout the exchange.

2. Make an Offer for the Property You’re Interested In

Once you select your EAT, you’ll need to arrange to purchase the replacement property. When you enter into a purchase and sales agreement with the seller, you should specify that the purchase is part of a 1031 reverse exchange.

3. Arrange for the EAT to Take Title

At this stage, the EAT will take care of any necessary paperwork to set the reverse 1031 exchange up before closing. During this phase, you’ll also need to figure out how you or your client is paying for the property. If you’re using cash, you’ll want to let the closing parties know as soon as possible.

4. Identify the Property You Want to Sell

Before a reverse 1031 exchange can be completed, figure out which existing property will be sold. Every property has to be a real property that is like-kind in nature. Under the IRS’s rules, investors have 45 days from purchasing their new property to choose a property to relinquish in the exchange. Failure to do so could cause the exchange to fail, which means that the property could not be used as the replacement property.

5. Sell Your Property

After the EAT takes title to the replacement property, you’ll have 180 days to sell your relinquished property before completing the reverse 1031 exchange.

6. Finalize

To formally complete the reverse 1031 exchange, close on the sale of the relinquished property. Funds can be applied by EAT to either repay you for the initial cash you advanced it, or to a third-party lender to pay down any loan on the property. The title will simultaneously be transferred to you or your client.

What Rules Must Be Followed for Reverse 1031 Exchanges?

There are a few key 1031 exchange rules that everyone must follow when initiating a reverse 1031 exchange:

• You have 45 days to identify a property to relinquish and 180 days to finish the exchange.

• The replacement property must be of equal or greater value.

• It must be a like-kind exchange.

• You must work with a qualified intermediary.

Failure to follow these rules could increase your tax liability and cause your reverse exchange to fall through. There are many reasons to choose a reverse 1031 exchange. If you think this strategy is right for you, it’s important to find a partner you can trust. Contact the First American Exchange Company team to learn more about your options.

Reverse 1031 Exchange FAQs

What are the benefits of a reverse 1031 exchange?

The biggest benefit of a reverse exchange is that you have more time to choose a replacement property. When an investor purchases replacement property first, they can choose one that better aligns with their goals and has the greatest benefit to their portfolio.

What are the disadvantages of a reverse 1031 exchange?

If you fail to sell your relinquished property before the 180-day deadline, you’ll end up owning both the replacement and the relinquished properties. This could increase your maintenance costs and may cause you to lose out on any potential tax savings.

Does a reverse 1031 exchange offer the same tax deferral benefits?

Yes, reverse exchanges offer the same tax deferral benefits as delayed 1031 exchanges. However, you must meet all deadlines to qualify for any capital gains tax savings.