Reverse 1031 Exchange

By Thomas P. Roussel | November 21, 2022

 

Reverse 1031 Exchange

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.

A reverse 1031 exchange is the opposite of a delayed 1031 exchange.

What Is a Reverse 1031 Exchange? 

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.

With a 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, 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 qualified exchange accommodation arrangement assists with 1031 exchanges in real estate.

What Is a Qualified Exchange Accommodation Arrangement?

A qualified exchange accommodation arrangement (QEAA) is a tax practice that assists with 1031 exchanges in real estate. In this process, a third party accommodates the exchange by temporarily holding an investor’s relinquished or replacement property. This arrangement lets investors comply with the 1031 exchange guidelines under Section 1031 of the IRC. This tax code lets real estate investors defer paying taxes on the sales income on their property if they replace it with a like-kind property.

Though investors must follow strict guidelines for meeting a reverse 1031 exchange, a QEAA can facilitate the requirements and make this process much more efficient. This arrangement can simplify qualifications for tax deferral and increase flexibility for real estate investors in the timing of sales.

A QEAA is conducted by a qualified intermediary (QI) who functions as the exchange accommodation titleholder (EAT). In a reverse 1031 exchange, the EAT holds onto the new property title until the investor relinquishes the old property, allowing the investor to finalize the rest of the transaction and still defer capital gains tax.

A reverse 1031 exchange follows similar rules and requirements but in the opposite order.

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:

Property Value

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 Internal Revenue Service (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 value 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.

Timeline

An investor who uses a reverse 1031 exchange must identify the property they will relinquish within 45 days of purchasing the new property. After identifying the property, the investor must sell it within 180 days of buying the new property. The 45-day timeline and 180-day timeline run simultaneously.

Pros and Cons of a Reverse 1031 Exchange

Reverse 1031 exchanges come with several benefits and challenges you should consider before deciding if this approach suits your investment objectives. Here are some pros and cons to keep in mind before engaging in a reverse 1031 exchange:

One advantage of a reverse 1031 exchange is the safe harbor within the Revenue Procedure 2000-37.

Pros

One of the most significant advantages of a reverse 1031 exchange is the safe harbor within the Revenue Procedure 2000-37. This safe harbor allows the investor to park the replacement property with an EAT and make them the legal owner. This arrangement enables the investor to access various tax benefits within the safe harbor arrangements.

By following the required guidelines, such as purchasing a like-kind property and hiring a QI, the investor is eligible for a tax deferral, which means they could potentially reinvest hundreds of thousands of dollars or more into a new investment property. A reverse 1031 exchange allows reinvestment in multiple properties, which opens up more opportunities for the investor to trade up in real estate and build their wealth in a larger or more profitable property.

A reverse 1031 exchange can also be beneficial in the volatile real estate market, which is prone to rapid changes. This type of exchange lets investors lock in a replacement property at the right price and time that suits their needs and financial goals. Additionally, listing the relinquished property after purchasing a replacement can give investors more control over the closing price and contract conditions by negotiating with the buyer over the terms and contingencies to ensure they meet the requisite time frames.

Additionally, if your current property has issues that may affect a quick sale, a reverse 1031 exchange can jump-start the process. A reverse exchange can also give you more time to find a new property to acquire since you won’t have to rush to find a replacement property within 45 days.

Reverse 1031 exchange can be more complex than a delayed 1031 exchange, so it often requires more planning.

Cons

While there are plenty of benefits to a reverse 1031 exchange, there are also some challenges. Firstly, a reverse 1031 exchange can be more complex than a delayed 1031 exchange, so it often requires more planning. For example, the investor needs the money to purchase the new property before obtaining the proceeds of the relinquished property. Some investors will need to secure financing and loans to purchase the new property before selling the old one.

In a regular 1031 exchange, investors use the proceeds from the initial sale to buy the new property, which is usually more straightforward. Secondly, if you don’t sell your relinquished property within the 180-day timeline, your exchange will be invalid, and you will have to pay capital gain taxes.

Finally, a reverse 1031 exchange may cost more than a delayed 1031 exchange. Depending on your state, you may have to pay a transfer tax when switching the title to and from your EAT. Additional reverse 1031 exchange fees may occur due to multiple closings in this process. However, every location is different.

Considerations for 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:

Funding

Funding

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

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.

Two parking approaches:

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.

What’s the Process for a 1031 Reverse Exchange?

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 exchange accommodation titleholder (EAT) to hold the parked replacement property title throughout the reverse exchange process. The EAT and the investor enter into a Qualified Exchange Accommodation Agreement (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.

The Importance of Choosing the Right EAT

An EAT is an integral part of the reverse 1031 exchange process. As with a QI, you must choose your EAT carefully so they can help you seamlessly facilitate the exchange. The EAT you choose may also be responsible for making certain improvements to the replacement property during the exchange period, if needed, before transferring it back to the investor by the 180th day.

Therefore, relying on a trustworthy and qualified EAT to hold the legal title to your property can significantly affect the outcome of your exchange.

Contact Us

Learn More About Reverse Exchanges

A reverse 1031 exchange can benefit your investment goals and allow you to defer capital gains tax, giving you more flexibility to reinvest in a more profitable property. When you create an investor account at 1031 Crowdfunding, you gain access to an extensive online marketplace of 1031 exchange properties, making it easier to identify an appropriate replacement property.

An investor account also gives you access to support from our expert team, who can guide you through the 1031 exchange process and assist you in finding an investment that suits your needs. The professionals at 1031 Crowdfunding will help you abide by the 1031 exchange terms and reap the rewards of various investment opportunities. Register for an investor account today to browse available properties and learn more about why clients rely on us for our turnkey solutions to 1031 exchanges.

 

This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.

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