Reverse 1031 Exchanges
Section 1031 of the Internal Revenue Code permits taxpayers to defer capital gains tax when an investment property is transferred in exchange for another like-kind property. These properties cannot be used for personal purposes and must be investment properties. To accomplish the exchange, investors can use several different methods, including a reverse exchange.
A reverse 1031 exchange allows an investor to buy a new investment property before selling their old or relinquished property. Here’s what you need to understand about these exchanges.
What Is a Reverse 1031 Exchange?
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—the property you already own.
These exchanges give real estate investors a bit more flexibility to make an offer on a property of interest without waiting for their relinquished property to sell. For investors purchasing in competitive markets, this makes it easier to get a valuable property that benefits their portfolios. These reverse exchanges are accomplished by using an Exchange Accommodation Titleholder (EAT)—an entity that steps in to take title to the property while the taxpayer finds a buyer for their relinquished property.
The Common Types of Reverse Exchanges
There are several different types of reverse exchanges that investors can consider, including ‘exchange first’ and ‘exchange last’ transactions. Let’s take a look at how these work.
Exchange First
A transaction where the relinquished property is parked with the EAT is referred to as an 'exchange first' transaction. The EAT usually takes title to the relinquished property immediately before the taxpayer’s acquires the replacement property through a forward exchange. The EAT acquires title using a loan from the taxpayer, and those funds are used for the purchase of the replacement property.
While the forward exchange is over quickly, the parking transaction 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—including the loan from the taxpayer for the initial parking of the property.
Occasionally, a qualified intermediary may require an 'exchange first' transaction because of identified environmental issues with the replacement property, or issues involving the replacement property lender. 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.
Exchange Last
In an 'exchange last' transaction, 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. The taxpayer must close on the relinquished property within the exchange period, 180 days from the closing of the replacement property. When the relinquished property is sold, the sales proceeds come to the qualified intermediary and their forward exchange occurs. Then, EAT completes the exchange by directly transferring the deed to the replacement property to the taxpayer and providing net proceeds to the sale to the taxpayer in repayment of their original loan.
The 'exchange last' transaction 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 when they own more than one, or when they don’t have cash to loan the EAT and need to obtain third party financing for 100% of the purchase.
After the relinquished property has been transferred to the buyer, the replacement property and any net sales proceeds from the relinquished property are transferred to the taxpayer to complete the exchange.
How to Perform a Reverse Exchange
Almost every reverse 1031 exchange follows a similar process. Here are the steps you’ll need to take to complete your exchange.
1. Find an Exchange Accommodator Titleholder (EAT)
Before investors can move the process along, they need to identify a qualified exchange accommodator titleholder (EAT). This entity is responsible for taking possession of the title until the property owner sells their relinquished property.
The EAT can be an individual or a company that specializes in helping real estate investors complete 1031 exchanges, such as a qualified intermediary. They 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. The title remains with the EAT for up to 180 days—the deadline for finalizing the reverse 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
You will work with all parties to the closing to ensure that the EAT is assigned into the purchase. The closing attorney or settlement agents will prepare a deed and any other required documentation for the transfer of title to the EAT. At this stage, the EAT (or qualified intermediary providing the EAT) will take care of any necessary paperwork to set the 1031 exchange up prior to closing. During this phase, you’ll also need to figure out how you’re paying for the property. If you’re using cash, let the closing parties know. If you’re financing the purchase with a loan, you’ll need to secure financing at this time. Work with your preferred lender.
4. Identify the Property You Want to Sell
Before you can complete the reverse exchange, you’ll need to figure out which of your existing properties you want to sell. Remember, every property involved in a 1031 exchange must be real property that is like-kind in nature. It must also be an investment property rather than a personal property.
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 in the exchange once the relinquished property actually sells. Once you choose a property, you have 180 days to close on the exchange if you want to have a successful reverse exchange.
5. Sell Your Property
Before you can complete the exchange, you’ll need to sell your relinquished property. After the EAT takes title to the replacement property, you’ll have 180 days to sell your relinquished property. Keep in mind that you may find it easier and faster to sell if you work with a real estate agent.
6. Finalize the Exchange
To complete the exchange, you’ll need to close on the sale of your relinquished property. Proceeds will come to the qualified intermediary in a forward exchange and be used for the purchase of the replacement property. The EAT will fulfill the seller’s role in the closing.
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. Title will simultaneously be transferred to you.
The Reverse 1031 Exchange Timeline
Reverse exchanges are subject to the same timeline as all 1031 exchanges. After finding a replacement property, you have 45 days to identify a property you own that you’ll relinquish. You have a total of 180 days to finish the exchange from the day you close on the property you want to buy. Failure to meet those deadlines could cause your reverse exchange to fail, making the property ineligible for an eventual exchange of your relinquished property.
Important Reverse 1031 Exchange Rules to Follow
There are a few key rules that all investors need to follow when initiating a reverse 1031 exchange. Here’s what you need to know before you start the process:
- The property must be of equal or greater value. The property you’re purchasing must have a value that’s equal to or greater than the property you’re relinquishing.
- It must be a like-kind exchange. To qualify for a reverse 1031 exchange, investors must exchange real estate interests of similar or like-kind nature (for example, a fee interest in real property for a fee interest).
- You must adhere to all timelines. Failure to meet required deadlines could leave you responsible for capital gains taxes when you file your tax return.
- You must work with a Qualified Intermediary. Qualified Intermediaries make sure exchanges go smoothly and legally. To conduct a reverse exchange, you’ll need to work with a Qualified Intermediary who will oversee the process.
Failure to follow these rules could increase your tax liability and cause your reverse exchange to fall through.
Why Choose a Reverse Exchange?
Investors often choose reverse 1031 exchanges when investing in a challenging market. Since you’re able to choose the replacement property first, you’re able to take your time during your search. This gives you a better opportunity to find a property that meets your needs, has adequate growth potential, and serves your portfolio.
With a standard 1031 exchange, you have to sell your property first before you can start trying to buy a replacement. If the market is competitive, finding a replacement property before the deadline is up can be difficult. Reverse exchanges give you more flexibility to focus on finding a property you’re interested in without having to worry about the timeline or having to make a rush decision.
Reverse 1031 Exchange FAQs
Here are a few frequently asked questions about reverse 1031 exchanges.
What are the benefits of a reverse 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 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.
Reverse Exchanges Can Make Diversification Easy
Reverse 1031 exchanges can help you pursue different investment opportunities and take advantage of capital gains tax deferral and savings without forcing you to rush to find a replacement property before completing the exchange. But to complete your exchange, you will need to work with an experienced EAT and Qualified Individual.
If you think a reverse exchange is in your best interest, you’ll need to find a partner you can trust. Start your exchange with First American Exchange Company or speak with our reverse 1031 exchange team to learn more about your options.