Real estate investors have various instruments for taking advantage of opportunities. For example, the reverse 1031 exchange plan reverses the order of the typical 1031 exchange process so that you can buy a new property before selling — and exchanging — the present one. The reverse 1031 allows you to not only act promptly on an attractive offer but also allows you to time the sale of your existing property to maximize possible profit.
While the reverse 1031 exchange is more complicated and costly, it can also open the door to a profitable transaction. If you’re considering this type of transaction, read for more information.
- Investors must reinvest 100% of the sales proceeds to defer the entire capital gain tax liability.
- A reverse 1031 exchange is where investors purchase a replacement property before selling their already-owned investment property.
The Reverse 1031 Process
The reverse 1031 exchange can be used to buy investment properties such as commercial buildings, multifamily units, warehouses, undeveloped land, and rental houses, but not primary or secondary residences. Similar to a typical 1031 exchange, the properties must be “like kind,” which implies that both must be utilized in a company or for investment, but they do not have to be the same real estate. You can still exchange an office building for another office building or a different investment property, such as a hotel, rental residential property, raw land, a shopping center, etc.
A reverse 1031 exchange will necessitate a unique type of short-term financing. Only a few lenders and institutions provide this service, which must also include the involvement of a qualified middleman (QI). You can also use cash to purchase the home if you have the funds.
The new home must be purchased in your QI’s name, and that entity will maintain the title to the property until you sell your previous investment, which must be worth the same as or less than the new asset’s purchase price. Otherwise, you must pay taxes on the profit from the original property’s sale.
Within 45 days of closing the new property, you must identify one or more presently held investment properties to swap for the new replacement property. The same identification standards apply to reverse 1031 exchanges as traditional 1031 exchanges, such as “the three property rule”, “the 200 percent rule.” Furthermore, for the reverse 1031 transaction to be successful, the designated property must be sold within 180 days of purchasing and the replacement property transferred from the QI to the investor.
While a reverse 1031 has advantages, it is not for everyone. Keep the following points in mind:
- This method can only be used to purchase an investment property; if used to buy a home, you cannot live in it as your primary residence for at least two years following the sale.
- Fees for a reverse 1031 exchange can quickly build up and may exceed $10,000, compared to $1,500 for a standard 1031 exchange. These expenses exclude the high financing fees of a short-term loan.
- In a competitive real estate market, sellers may need to be more experienced with this tactic and may be hesitant to accept your offer. Working with an agent who can thoroughly explain the aspect of the deal and dispel any questions is essential. Having bridge funding in place ahead of time can increase your chances of winning a bid.
- If you don’t sell your original property within 180 days, you will either possess both properties or lose your claim to the new property and your earnest money (if the transaction is yet to be closed). While many markets are currently competitive, rising mortgage rates may hinder sales, endangering your 180-day reverse 1031 exchange limit. Your agent should keep this transaction component private since prospective purchasers will use it to their advantage.
- You must be able to demonstrate financial capability to purchase the new property. In other words, even if the reverse 1031 exchange does not go as planned, you must have either cash or a loan to complete the transaction.
Investment.org has the experience with 1031 exchanges and reverse 1031 exchanges that you need to preserve your investment and financial interests. Contact our advisors today to discuss your next steps toward achieving your real estate investing goals.