A 1031 exchange is a tax deferral process from Section 1031 of the U.S. Internal Revenue Code (IRC) that allows real estate investors to defer taxes on capital gains if they relinquish one investment property and invest the proceeds in another. Investors must follow certain regulations to reap these financial benefits but can take advantage of this practice to trade up their properties and expand their portfolios.
However, there are different types of 1031 exchanges, including simultaneous, delayed, and reverse. This article covers the considerations and requirements of reverse 1031 exchanges and how they differ from other types of this tax deferral.
What Is a Reverse 1031 Exchange?
A reverse 1031 is when an investor acquires the replacement property before they have relinquished their old property. With this exchange, an exchange accommodation titleholder (EAT) holds the target property — or the parked property — in a special purpose entity such as a single-member LLC. The 1031 reverse is complete when the EAT takes title to the relinquished property or replacement property under a qualified exchange accommodation arrangement (QEAA).
With a 1031 reverse exchange, an investor acquires the replacement property before transferring the relinquished property. Buying a new property first — which must be an investment property of equal or greater value to the old one — starts the 180-day timeline to sell the old property. A reverse exchange may enable the investor to hold their current property until its market value increases, allowing them to maximize their profit.
Reverse 1031 exchanges also empower real estate investors to seize other opportunities, including:
- More potential control over the rapidly changing real estate market by locking in the replacement property at the right time and price
- More time to choose and negotiate a strong deal on the replacement property that aligns with your investment strategy
- More flexibility to stay within the 180-day timeline and negotiate contracts because you’ve already found the replacement property
However, as with any real estate investment, there are potential downsides that you must consider with a reverse 1031, such as:
- Investors need to have sufficient funds to purchase the new property before they acquire the funds of their relinquished property
- Investors must sell their relinquished property in 180 days or risk losing 1031 exchange benefits
- Additional fees and taxes may apply depending on the location
A reverse 1031 exchange is the opposite of a delayed 1031 exchange. In a delayed 1031 exchange, investors sell their relinquished property and identify and close on their replacement property or properties within 180 days. The case where the investor owns the replacement and relinquished properties simultaneously is referred to as a pure reverse exchange. This method, however, is not permitted by the Internal Revenue Service (IRS), and you will be taxed on your gains. Always involve an EAT in a reverse exchange to avoid costly mistakes.
What Are the Requirements for a Reverse 1031 Exchange?
As with a regular delayed 1031 exchange, a reverse 1031 exchange follows similar rules and requirements but in the opposite order. As with all 1031 exchanges, this type of exchange only works when trading business or investment properties, such as rental properties or apartment buildings. Here are a few other rules an investor must follow for a reverse 1031 exchange:
The new property must have an equal or greater value than the relinquished property. In a reverse exchange, the investor must purchase a property that falls within those requirements before selling their old property to remain eligible for the 1031 exchange tax benefits. If the new property is of lesser market value than the one they plan to sell, the IRS will tax the investor on the remaining income after relinquishing that property.
Use of Funds
In any 1031 exchange, the seller must use the proceeds from the sale of their relinquished property to reinvest in the new exchange property to gain tax benefits. For instance, if an investor uses some of the sales funds to buy themselves a new car or start an online business, that money would be taxed.
Type of Property
Both properties must be like-kind, meaning an investor must purchase a property they intend to use for a business, trade, or investment purpose. The quality and grade of the property don’t matter, only how the investor will use it. Exchanging an apartment complex for an industrial building or condos for a retail center would fall under like-kind exchanges.
A reverse exchange is subject to the same identification and exchange periods as a traditional 1031 exchange. An investor who uses a reverse 1031 exchange must identify the property they will relinquish in writing within 45 days of purchasing the new property. This written identification must be delivered to the EAT, qualified intermediary, or another party involved in the exchange.
After identifying the property, the investor must sell the relinquished property within 180 days of buying the new property. On or before the deadline, the EAT must transfer the parked replacement property or parked relinquished property to a third-party buyer. This transfer completes the reverse 1031 exchange.
The 45-day timeline and 180-day timeline run simultaneously. If the reverse 1031 exchange timeline is not met, the investor will no longer have the safe harbor benefits.
How Does a Reverse 1031 Exchange Work?
A reverse 1031 exchange helps investors acquire a new property quickly without having to sell a like-kind property first. This process enables them to focus on selling their investment property instead of finding a new one within a specific timeline. Here’s a closer look at the necessary steps in the reverse 1031 exchange:
1. The Investor Identifies an EAT
The investor chooses an EAT to hold the parked replacement property title throughout the reverse exchange process. The EAT and the investor enter into a QEAA and outline the terms and conditions of the exchange.
2. The Investor Buys the Replacement Property
Next, the real estate investor purchases the new investment property to replace their current property. As mentioned above, the replacement property must be like-kind and of equal or greater value to the property they want to relinquish. The investor purchases the replacement property by financing a loan through a mortgage lender or paying cash.
3. The EAT Takes Control of the New Property Title
Once the investor completes the QEAA with an EAT and closes on the sale of the replacement property, the EAT takes possession of the legal title for the new property so the investor will not own both properties at once. This step is critical to qualifying for 1031 exchange tax benefits.
4. The Investor Chooses Which Property to Sell
After buying the new property, the investor must decide which property or properties to sell from their current portfolio. However, most investors predetermine which property they will sell. The investor must identify the existing investment property they will relinquish within 45 days of closing on the replacement property.
5. The Investor Uses a Qualified Intermediary to Establish a Contract
The investor will use a qualified intermediary (QI) to create a contract that gives the QI the right to hold and transfer the title of the relinquished property to the new buyer once they are found. The QI is also responsible for transferring the title of the replacement property from the EAT to the investor.
6. The Investor and Relinquished Property Buyer Enter the Contract
Once the investor finds a buyer for the relinquished property, they enter into a contract to sell it. Keep in mind that these reverse 1031 exchange documents should list the EAT as the seller of the property for tax purposes because they will be the current title holder during the exchange.
7. The Relinquished Property Sells
Within 180 days of purchasing the replacement property, the investor must close on the sale of the relinquished property or properties. From there, the investor’s EAT will transfer the title of the replacement property to the investor. If this process occurs within the 180-day timeline and meets all other requirements, the investor is eligible for tax-deferral on the proceeds from the sale of the relinquished property in the reverse exchange.
What to Consider Before a Reverse 1031 Exchange
A delayed 1031 exchange is a bit more straightforward than a reverse 1031 exchange. Because this process involves the same steps in a different order, investors may need to understand a few factors before beginning a reverse exchange. Here are some items to consider:
In a reverse 1031 exchange, the investor must have the financial means to purchase a replacement property without having the proceeds from the relinquished property sale. Since the investor has not yet sold the relinquished property, they must find other financial resources to acquire the new, like-kind property.
If an investor requires a commercial loan to acquire the replacement property, the EAT holds the money. Because the EAT also holds the new property in a reverse 1031 exchange, they will need to be involved in the loan process.
Parking is a term the IRS uses to refer to the EAT holding title to the relinquished or replacement property during a reverse exchange. “Parking” may also be referred to as “station,” “place,” or “warehouse.” Investors use the parking technique because the Revenue Procedure 2000-37 states that the exchanger cannot own the relinquished and replacement property at the same time during any type of 1031 exchange.
Investors use one of two parking approaches to complete a reverse exchange. The first is to park the replacement property, and the second is to park the relinquished property. Several factors will help investors decide which property to park, including:
- The funding for the acquisition
- Liens on the relinquished property
- Equity in the relinquished property
For example, the investor must park the replacement property if they want to improve it. Any construction or improvements must be made before the investor can hold title to the property. However, whichever property they park, the investor still has access. The EAT and investor generally create a property management and lease agreement that allows the investor to access the parked property.
1. Park Replacement Property
With this method, an EAT creates a single member limited liability company (LLC) with the replacement property as the sole asset. The LLC then acts as the EAT and borrows money from the investor or lender to purchase the replacement property.
The LLC owns the new property until the investor sells the relinquished property. Once the investor sells the relinquished property, the proceeds go to the LLC to pay off any loans. Finally, the LLC transfers ownership of the property to the investor to complete the 1031 exchange.
2. Park Relinquished Property
With this approach, the EAT creates a single member LLC with the relinquished property as the sole asset. Then the LLC obtains the replacement property and exchanges it with the relinquished property. In this exchange, the LLC essentially transfers the replacement property to the investor, and the investor transfers the relinquished property to the LLC.
The LLC owns the relinquished property until a buyer is found. During the closing, the LLC transfers the title of the relinquished property to the buyer. Then the proceeds go to the LLC to pay off any loans they incurred to acquire the replacement property.
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