Most real estate investors are familiar with traditional tax-deferred exchanges. They require you to sell your current business property before you can purchase another. However, there’s an alternative route that allows you to take some extra control in the unpredictable real estate market. A reverse 1031 exchange is a tax-deferred method that provides a variety of potential benefits. But it requires a careful strategy and knowledge of legal guidelines. Here’s what you need to know about them before diving in.
Consider working with a financial advisor as you seek ways to handle real estate matters in a way that minimizes taxes.
What Is a Reverse 1031 Exchange?
A reverse exchange is a maneuver that investors employ in real estate. This type of property exchange involves purchasing a replacement property before selling or trading the currently owned property. The investor must sell or transfer that original property, though, since owning both at the same time (or a “pure” reverse exchange) is not allowed.
But there are other types of 1031 exchanges as well. For example, there is the most common form, called “forward 1031 exchange.” Otherwise known as a like-kind exchange, delayed exchange or starker exchange, it describes selling and closing the original property before finalizing the purchase of a new property. There is also:
- Simultaneous exchange: when you purchase the replacement property and sell the current property at the same time.
- Delayed build-to-suit exchange: when you replace the current property with a new property built to match the investor’s needs.
- Delayed/Simultaneous built-to-suit exchange: when you buy the built-to-suit property before transferring the current property.
Reverse exchanges solely apply to Section 1031 property, which usually must be investment or business property. The regulation may also apply to a previous primary residence or vacation home, but only when meeting very specific conditions.
However, while you can expedite the process, you can’t take ownership of the replacement property immediately. You have to complete the entire transaction first. Until the sale of the relinquished property, an intermediary called the exchange accommodation titleholder (EAT) must hold the property. Parking the property with an EAT is called a qualified exchange accommodation arrangement (QEAA).
Structure of a Reverse 1031 Exchange
There are two ways you can format your reverse 1031 exchange. They are:
Exchange First Reverse 1031 Exchange
In this case, the EAT takes the title of the relinquished property before the investor purchases the replacement. The price is based on the estimated fair market value; however, the investor provides the funds to the EAT. But you maintain control over the property when you sign a QEAA and lease.
The EAT then also takes possession of the replacement property.
Within 180 days of the EAT taking the replacement property’s title, you must close the relinquished property’s sale. You then receive these proceeds as reimbursement for the funds you gave to the EAT to buy the relinquished property.
Exchange Last Reverse 1031 Exchange
Here, the EAT takes possession of the replacement property as soon as you close on the purchase. You provide the funds to do so, although the EAT is named the borrower on any financing.
Within 180 days of this purchase, a qualified intermediary sells the relinquished property on your behalf. Then the sale proceeds are used to buy the replacement property from the EAT.
Afterward, the EAT transfers the replacement property title to you, and the qualified intermediary transfers the relinquished property sale proceeds to the EAT. Finally, the EAT uses said funds to pay off any existing debt from the replacement property purchase.
1031 Exchange Time Periods
Generally, an exchange occurs when you swap one property for another. But it’s not easy to locate the exact type of property you want, which can mean delays. Two timing rules apply to the 1031 exchange, though.
The first is the 45-day rule. Once you sell your property, you need to identify the replacement to your intermediary within 45 days. It should be in writing and detail the property you want. Investors can designate three properties as long as they choose one to purchase. It’s possible to designate more than the base three sometimes, although it depends on their valuation.
The second is the 180-day rule. Simply, you must close on your new property within 180 days of the old property’s sale.
Reverse Exchange Key Timing Considerations
So, the timeline for reverse exchanges mirrors the deadlines used in a deferred exchange. If you fail to meet the 45- and 180-day deadlines, you don’t lose or disqualify the transaction. However, you will no longer be able to enjoy the benefits available through the presumption of the safe harbor. Anyone participating in a reverse 1031 exchange needs to keep these time period tweaks in mind:
- 45-Day Deadline: The exchanger must communicate with the EAT in writing and identify the properties that may be relinquished. This is done prior to or on the 45th day following the EAT’s acquisition of the target property.
- 180-Day Deadline: The EAT must transfer the replacement property to the exchanger, or the current, relinquished property to a third party. This must be done on or prior to the 180th day after the EAT acquires the target property.
- Concurrent Deadlines: Both the above deadlines run at the same time. Also, the 180-day parking period (exchange last reverse) and the 180-day exchange period are independent of each other.
Like-Kind Property in a Reverse Exchange
Section 1031 of the IRC requires any investment real estate involved in a 1031 exchange to be “like-kind.” According to the IRS, like-kind exchanges are “real property used for business or held as an investment [exchanged] solely for other business or investment property that is the same type.” So, its character defines it rather than its grade or quality.
The range of exchangeable real estate is broad as a result. For example, you can exchange vacant land for a commercial building. However, you can’t swap real estate for another tangible asset, such as gold or artwork. Usually, exchangers must have owned the property for a minimum of two years. Finding a replacement property with equal or greater value will also help you receive the full benefit of your 1031 exchange.
Purchasing a property with lesser market value incurs taxes on the remaining income made from the relinquished property sale.
There are three rules that you can use to designate your replacement property. They are:
- The three-property rule: identify three properties for possible purchase, no matter their market value.
- The 200% rule: identify any number of properties for replacement as long as their total fair market value does not exceed 200% of the relinquished property’s fair market value.
- The 95% rule: identify any number of properties up to and over 200% of the relinquished property’s value, but only if the exchanger acquires at least 95% of the total identified properties’ value.
Reverse 1031 Exchange: Pros and Cons
Reverse 1031 exchanges may help or hurt your real estate investment strategy. Keep these factors in mind before you start planning.
Advantages of a Reverse 1031 Exchange
The main appeal of a reverse 1031 exchange is the safe harbor that the IRS created with Revenue Procedure 2000-37. It requires the exchanger to park the replacement property with the EAT. Because of this, they are the legal owner, which opens up a list of tax benefits, also known as safe harbor arrangements.
Additionally, following the required guidelines (i.e., hiring a qualified intermediary, purchasing a like-kind property, etc.) makes the investor eligible for tax deferral. This applies to the sales income made from the relinquished property.
However, there are other benefits to this strategy worth considering. For example, the real estate market can be volatile and subject to rapid changes. A reverse 1031 allows you to lock in a replacement property at a time and price that suits you. It also gives you more control over your own closing price when you list the relinquished property after purchasing the replacement.
Challenges of a Reverse 1031 Exchange
Reverse 1031 exchanges are more complex than forward 1031 exchanges and thus require more careful planning. For example, one of the most difficult challenges comes with financing. Securing a loan in a tight credit market can be difficult. You might not have access to cash to help you make the exchange quickly, and working with a lender creates restraints. And if you don’t sell within the 180-day deadline, then both assets are owned.
Missing the 180-day deadline also costs you any favorable tax treatment. You’ll have to pay capital gain taxes.
It can be more costly than a deferred exchange, too. Your state may require a transfer tax when conveying the property title to and from the EAT as well. Some states view the EAT’s position as an agent of the exchanger, in which case they do not apply the tax. However, each location is different. Multiple closings also contribute to higher costs as well as service fees.
Reverse 1031 exchanges are a valuable tool to have in a real estate investor’s back pocket. They allow you to purchase your replacement property before selling the one you currently hold. But they’re a complex strategy, which can incur additional expenses if you’re not careful. Speaking with a tax advisor and knowledgeable qualified intermediary will help you navigate this process. They can guide you through the rules applicable to you as a taxpayer.
Tips for Real Estate Investing
- Real estate is a valuable way to diversify and strengthen your portfolio. However, it also comes with a range of risks. Talking to a financial advisor before you start planning will help you mitigate potential losses. Finding the right one is easy with SmartAsset’s free matching tool. It matches you with local professionals in only minutes. If you’re ready to revise your investment strategy, get started now.
- If you’re interested in broadening your investment horizons, you may also need to revisit your asset allocation. Finding the right balance can help you ensure your strategy matches your risk tolerance. Check out our asset allocation calculator to review your current portfolio.
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