A 1031 exchange is a tax deferral process from Section 1031 of the U.S. Internal Revenue Code (IRC). It 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 specific regulations to reap these financial benefits but can use this practice to trade up their properties and expand their portfolios.
A 1031 exchange can be simultaneous, delayed, or reversed. Compared to other tax deferral methods, reverse 1031 exchanges have different considerations and requirements.
Reverse 1031 Exchanges: What Are They?
A reverse 1031 occurs when an investor acquires a replacement property before selling their old one. A single-member LLC or an exchange accommodation titleholder (EAT) holds the target property – parked property – in this exchange. When a qualified exchange accommodation arrangement (QEAA) takes title to the relinquished or replacement property, the 1031 reverse is complete.
1031 reverse exchanges involve an investor purchasing a replacement property before selling the relinquished property. When you buy a new investment property first – one of equal or more excellent value than the old one – the 180-day period for selling the old property begins. Reverse exchanges allow investors to hold their current properties until their market value increases, maximizing profits.
Real estate investors can also take advantage of other opportunities with reverse 1031 exchanges, including:
- Locking in the replacement property at the right time and price gives you more control over the rapidly changing real estate market.
- Your investment strategy will align more with the replacement property you choose and negotiate.
- Because you’ve already found the replacement property, you have more flexibility to negotiate contracts and stay within the 180-day deadline.
With a reverse 1031, there are, however, potential downsides to consider, including:
- To acquire funds from the relinquished property, investors must have sufficient funds to purchase the new property.
- There is a 180-day deadline for selling relinquished property, or investors may lose their 1031 exchange benefits.
- Taxes and fees may vary by location.
- An exchange reversed from a delayed 1031 exchange is known as a reverse 1031 exchange. During a delayed 1031 exchange, investors sell their relinquished property, identify the replacement property or properties, and close within 180 days of selling them. In a pure reverse exchange, the investor owns both the new and relinquished properties simultaneously. However, you will be taxed on your gains if you use this method. An EAT should always handle reverse exchanges to prevent costly mistakes.
Reverse 1031 Exchanges – What Are the Requirements?
In a reverse 1031 exchange, the rules and requirements are similar to those of a delayed 1031 exchange, but they follow the opposite order. It is only possible to use this type of exchange when trading investment properties or business properties, such as rental properties or apartment buildings. Reverse 1031 exchanges must also follow a few other rules:
Value of a property
Relinquished property must have a value equal to or greater than the new property. To benefit from the 1031 exchange tax benefits, the investor must purchase a property that meets those requirements before selling their old property. When the investor relinquishes a property with a lesser market value than the one they plan to sell, the IRS will tax the remaining income.
Funding Arrangements
To gain tax benefits, the seller must reinvest the proceeds from selling their relinquished property in the new exchange property. Taxes would apply if an investor used some of the sales funds to purchase a new car or start an online business.
Type of Property
Investors must purchase properties they intend to use for business, trade, or investment purposes, meaning both properties must be like-kind. Only how the investor plans to use the property matters, not its quality or grade. The exchange of an apartment complex for an industrial building or condos for a retail center would qualify as a like-kind exchange.
Timeline
Identification and exchange periods apply to reverse exchanges and traditional 1031 exchanges. Within 45 days of purchasing the new property, an investor who uses a reverse 1031 exchange must identify the property they will relinquish in writing. An EAT, qualified intermediary, or other party involved in the exchange must receive this written identification. Investors are required to sell relinquished properties within 180 days of buying new properties.
A third-party buyer must receive the parked replacement or relinquished property on or before the deadline. The reverse 1031 exchange is complete with this transfer. Both the 45-day and 180-day timelines run simultaneously. Safe harbor benefits are only available if the reverse 1031 exchange timeline is met.
What is a Reverse 1031 Exchange?
The reverse 1031 exchange enables investors to acquire new property without selling their current property first. Using this method, they can focus on selling their investment property rather than finding a new one within a specified period. A reverse 1031 exchange involves the following steps:
1. Identifying an EAT by the investor
The investor decides whether an EAT will hold title to the parked replacement property during the reverse exchange process. A QEAA is entered into between the EAT and the investor.
2. The Investor Buys the Replacement Property
The real estate investor purchases a new investment property to replace their current investment property.
3. The EAT takes over the new property title
The EAT takes possession of the legal title for the replacement property once the investor completes the QEAA with an EAT and closes on the sale of the new property, so the investor will not own both properties at once. For 1031 exchanges to qualify for tax benefits, this step is crucial.
4. Choosing which property to sell is the investor’s decision
Once the investor has bought the new property, they must decide which property to sell from their existing portfolio. Most investors, however, decide in advance which properties they will sell. Upon closing on the replacement property, the investor must identify the existing investment property they will relinquish.
5. A qualified intermediary establishes the contract on behalf of the investor
The investor uses a qualified intermediary (QI) to create the contract to transfer ownership of the relinquished property to the new buyer. The QI is also responsible for moving the title from the EAT to the investor for the replacement property.
6. Contract between Investor and Relinquished Property Buyer
Investors enter into contracts to sell their relinquished properties once they find buyers. These reverse 1031 exchange documents should list the EAT as the property seller for tax purposes since they will be the current title holder.
7. Sale of the relinquished property
The investor must sell the relinquished property or properties within 180 days of purchasing the replacement property. In this case, the investor’s EAT will transfer the title of the replacement property to the investor. An investor may qualify for tax deferral on the proceeds from the sale of the relinquished property in a reverse exchange if the process occurs within the 180-day timeline and meets all other requirements.
Reverse 1031 Exchange: What to Consider?
It is easier to perform a delayed 1031 exchange than a reverse 1031 one. Before beginning a reverse exchange, investors may need to understand a few factors before beginning a reverse exchange because the process involves the same steps in a different order. The following items need to be considered:
Funding
Reverse 1031 exchanges require an investor to have the financial means to buy a replacement property without the proceeds from the relinquished property sale. The investor must find other financial resources to acquire the new, like-kind property.
Investors may borrow money from the EAT to acquire replacement properties. In a reverse 1031 exchange, the EAT also holds the new property, so they must be involved in the loan process.
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:
Learn More About Reverse 1031 Exchanges with Investment.org. Connect with our advisors today at 888-993-2835.
