A reverse 1031 exchange is a complicated financial strategy that involves the purchase of like-kind property before selling an existing property. It can be an appealing option for investors who want to take advantage of favorable market prices. The process allows the purchase of a new like-kind property backed by the future proceeds from the sale of an existing property.
We will go over the advantages of a reverse 1031 exchange to better understand how it can be used as a sound financial strategy. While there are advantages and disadvantages to this strategy, the tax benefits and ability to purchase in favorable market conditions may make it a beneficial approach when purchasing like-kind properties.
What is a Reverse 1031 Exchange?
A traditional 1031 exchange is when an investor sells off a property and purchases a new property with those finances. A reverse 1031 exchange works in the opposite way – an investor purchases a property and sells off another property to fund the purchase.
The investor has 180 days to sell the like-kind property. Funds are then used to pay for a new property without facing capital gains tax.
How does a Reverse 1031 Exchange Work?
A reverse 1031 exchange allows an investor to act on an enticing property immediately. It should be noted that the investor cannot hold the title of the new property until the existing property is sold. The title of the new property will remain with an Exchange Accommodation Titleholder (EAT) until the sale of the existing property is completed.
A reverse 1031 exchange gives investors time to postpone capital gain taxes on their property.
Structure of a Reverse 1031 Exchange
The Revenue Procedure 2000-37 forbids the acting party to have complete ownership of both the relinquished property and the replacement property at the same time.
There are two ways to approach the subject of a reverse 1031 – exchange last or exchange first.
The exchange last structure is the preferred strategy for both buyers and investors. It allows for more flexibility regarding the structuring and financing of the properties.
In an exchange last structure, the acquired property is “parked” by the EAT. After the closure of the relinquished property, the 1031 is eligible to be closed.
An exchange first approach is when the EAT takes possession of the relinquished title before the closing of the replacement property.
This method requires significantly more cash on hand for the buyer and offers less flexibility in the structuring and financing of both properties in question.
What is ‘Parking’?
This is an expression used frequently in discussions about reverse 1031 exchange. Parking refers to the process of the EAT taking possession and holding onto the title of a property during an exchange.
What Is the Process of a Reverse 1031 Exchange?
There are eight main steps in a reverse 1031 exchange. Below is the most common approach to a reverse 1031 exchange (an exchange last approach):
- Find and purchase a replacement property. You can use cash, conventional financing, or short-term private money loans to do so.
- Reach a qualified exchange accommodation agreement (QEAA) with your EAT. This is a formal, written agreement with your EAT to hold possession of the replacement property. An EAT is an unrelated party.
- Relinquish title and possession of the new property to EAT. Once the sale of the replacement property is finalized, the title and possession can be temporarily transferred to your EAT.
- Decide which property to sell. The property must be a like-property to the replacement property. We will talk further about specific guidelines later on in the article.
- Find a buyer for your property. Obtain a formal, written contract for the sale of your relinquished property. It is important to list your EAT as the seller of the relinquished property.
- Reach an agreement with your Qualified Intermediary (QI). The QI is responsible for transferring the title of the relinquished property to the buyer, as well as acquiring the title of the replacement property.
- Transfer the deed of the relinquished property. The buyer will purchase the relinquished property from your EAT.
- Obtain the deed of your new property. Once all transitions and money have gone through, the EAT will then transfer the deed of the replacement property to you.
While the process can be a tedious one, it may be worth it for investors looking to avoid costly capital gains taxes.
Reverse 1031 Exchange Timeline
The timeline for a reverse 1031 exchange mirrors those of a 1031 exchange.
- 45 days. The relinquished property must be identified within 45 days of purchasing the replacement property.
- 180 days. The closing of the sale of the relinquished property must be finalized within 180 days of purchasing the replacement property.
This timeline is enforced by the Internal Revenue Service (IRS) Revenue Procedure 2000-37.
Reverse 1031 Exchange Requirements
The requirements on property type and value for a reverse 1031 exchange are the same as for a 1031 exchange and are as follows:
- Property value. The replacement property must be equal to or greater in value than the relinquished property. Otherwise, a tax is triggered on the difference in value.
- “Like-kind” Property Exchange. The IRS defines “like-kind” property as those that have the same nature or characteristics, regardless of grade or quality. An example of this would be exchanging an office investment property for another office complex.
- Investment or business purposes. The properties involved in the exchange must be held for investment or business purposes. Neither the replacement property, nor the relinquished property can be a residence of the taxpayer.
It is necessary to keep those three requirements in mind while sorting through potential properties. Otherwise, the taxpayer will not reap the tax benefits of going through the strenuous process of the reverse 1031 exchange.
Reverse 1031 Exchange Rules
In addition to following the property requirements set forth on a reverse 1031 exchange, it is essential to follow the set rules.
- Timeline. The timeline defined above must be met. The exchange must be completed within 180 days of closing on the replacement property.
- Funds. All of the money received from the relinquished property must be used for the purchase of the replacement property.
- Exchange through a QI. The exchange must be facilitated by a QI to remain legitimate.
- Taxpayers. Both the buyer and seller must be U.S. taxpayers.
Understanding and following the rules and requirements is critical to receiving all the benefits of this process.
Advantages of a Reverse 1031 Exchange
Here are some advantages of the reverse 1031 exchange:
- Significant tax benefits. By requiring you to park property with EAT, a significant amount of tax benefits, or safe harbor arrangements, are made available to you.
- Eligible for tax deferral. When the specific requirements and guidelines are followed, you are also eligible for a tax deferral. This applies to the sales income from the relinquished property.
- Time and flexibility. You are given more time and flexibility in the real estate market. This allows you the power to purchase a replacement property at a price you are comfortable with and sell the relinquished property at a more favorable price.
Although there are many benefits involved, a reverse 1031 exchange may not be the right fit for everyone.
Disadvantages of a Reverse 1031 Exchange
Here are some of the disadvantages associated with a reverse 1031 exchange:
- Inability to meet the timeline. If you cannot meet the 180-day deadline, then the tax benefits become nonexistent. You will have to pay capital gains tax on the properties. This puts significant pressure on the ability to purchase and sell at desirable rates.
- Costly and complicated process. There are a lot of steps involved in a reverse 1031 exchange, which means more paperwork along the way. The extensive paperwork involved adds more paid players to the process. This means that a reverse 1031 will require significant money up-front.
While up-front money is involved, paid players like the EAT, QI, and QEAA help facilitate an easy transaction for investors.
How is a Reverse 1031 Exchange a Financial Strategy?
The reverse 1031 exchange is a favorable choice in a commercial real estate seller’s market. Because of the timeline and requirements, the investor has more influence over both the selling price and purchasing price of the properties.
You can purchase a replacement property at a favorable price and then sell the relinquished property at an equally favorable price.
This process also includes significant tax benefits, making it a sound financial strategy for high-profile commercial real estate investors who deal with non-owner-occupied investment properties.
How can a Reverse 1031 Fail?
A reverse 1031 exchange will fail if, for whatever reason, the investor is unable to sell the relinquished property within 180 days. This is a significant failure because not only will the investor lose all costs throughout the reverse 1031 exchange process, but will have to pay full taxes on the replacement property sold.
Is A Reverse 1031 Exchange The Right Strategy For You?
A reverse 1031 exchange is not a simple process, but when handled correctly, can save an investor significant amounts on taxes and closing costs. This process gives the investor more power and freedom over the price of their relinquished property, as well as the ability to purchase a replacement property under ideal conditions.
It’s important to weigh the advantages and disadvantages before embarking on the reverse 1031 exchange. Keep in mind that you must be able to meet the 180-day deadline for purchasing the replacement property.