Many people are familiar with the concept of 1031 exchange and understand the standard forward exchange, where a relinquished property is sold first before the replacement property is acquired. However, only a few savvy investors know about the reverse 1031 exchange.
A reverse 1031 exchange still follows the strict rules of a 1031 exchange. Only that this time, it allows the replacement property to be purchased first before the sale of the relinquished property – the reverse of a typical 1031 forward exchange. Suppose you recently heard about the concept and would want to understand its working, this article is for you. Read to the end!
What Is a Reverse 1031 Exchange?
A reverse 1031 exchange is a type of 1031 exchange whereby, for various reasons, the replacement property is purchased first before the relinquished or old property is sold. Like the forward exchange, it’s also a way for real estate investors to trade one investment property for another without incurring capital gain taxes.
The reverse 1031 exchange is ideal if:
- You unexpectedly find an investment opportunity that you must act on before selling the property you want to relinquish.
- You want to avoid the pressure of indicating interest in a like-kind property within the 45 days identification deadline and buying it within the 1031 exchange timelines of 180 days.
- Your relinquished property sale suddenly collapsed, and you don’t want to miss out on a good deal closing soon.
Regardless of your reasons for conducting a reverse 1031 exchange, it allows you to acquire a like-kind property that the IRS recognizes as eligible for tax deferral. After which, you can then list and sell your replacement property within the 1031 reverse exchange time limit.
Requirements for a Reverse 1031 Exchange
Like a typical 1031 exchange, the 1031 exchange reverse is available to investors trading investment properties. These Investment properties include rental properties, apartment buildings, vacation homes, office spaces, etcetera. However, it doesn’t include a primary residence. Other than that, here are the few requirements for a reverse 1031 exchange.
Property Type and Value
The IRS must consider the relinquished and replacement properties to be like-kind properties for tax to be deferred. More so, the replacement property value must also be equal to or greater in value when compared to the relinquished value.
If the new property has a market value lesser than the old one, the tax will be calculated and imposed on the remaining income from the sale of the relinquished property.
Finance
In a 1031 exchange, all the money received from the sale of a relinquished property is used to pay for the new property. However, since the relinquished property is sold last in a reverse 1031 exchange, it can’t be used to purchase the replacement property. Therefore, investors that want to conduct a reverse 1031 exchange will need to source funds to buy the new property.
Investors can try obtaining loans from commercial lenders to acquire the new property. However, only certain lenders support and finance a reverse 1031 transaction.
Parking Agreement
Since an investor can’t hold title for the two concerned properties at the same time, the title of one property needs to be parked under an agreement called a parking agreement or qualified exchange accommodation agreement until the 1031 transaction is completed.
The purpose of a parking agreement is to mediate the transfer of the title of the two properties within the required timeframe because it’s illegal for an investor to hold the title of two properties simultaneously.
If you, as an investor, decide to park the old property, you have to transfer ownership of the property to the EAT through a warranty deed. However, you’ll still be liable for all the property’s expenses like taxes, insurance, mortgage payments, operating costs etcetera.
You’ll still receive all yields as usual. Alternatively, If you decide to park your new property with the EAT, you can still finance the property’s renovations and improvement.
Timeline and Rules of a Reverse 1031 Exchange
The reverse 1031 exchange has a similar timeline and rules as the forward exchange. The rules of a reverse 1031 exchange are:
- Investors only have 180 days after the initial closing to complete a reverse 1031 transaction.
- The same taxpayer must perform the buying and selling of the properties involved.
- The new property must be equal to or greater in value than the relinquished property. If not, capital tax gain will be triggered on the difference.
- Both properties concerned in a reverse 1031 exchange are to be used for investment and trade purposes only. Therefore, none of the properties involved in the exchange can be the investor’s primary residence.
- Related parties and disqualified person rules apply.
- Provided neither of the concerned properties exists in a qualified exchange accommodation agreement, the reverse exchange 1031 safe harbor rules allows like-kind treatment.
How to Carry Out a Reverse 1031 Exchange
Reverse 1031 exchange has its perks which is why many investors use this option. To carry out a reverse 1031 exchange, you first have to identify the replacement property you want to buy, then follow the following steps.
- Look for a Qualified Intermediary. Since it’s not permitted for you to hold the title of both properties in a 1031 exchange, you must look for an investment property exchange services to act as Qualified Intermediaries or Exchange Accommodation Titleholder (EAT) to hold the title of one of the properties for the duration of the exchange. Then you’ll enter into a Qualified Exchange Accommodation Agreement (QEAA) together. This agreement will state the terms of the exchange.
- Enter a Purchase and Sales Agreement (PSA) with the seller of the new property to represent your interest in following through with the property’s purchase.
- The Qualified Intermediary organizes all the paperwork needed for the first stage of the closing.
- Identify the property to be sold (you only have 45 days after purchasing the new property to identify its replacement property. You also have only 180 days from the date you acquired your new asset to finalize the sales of the old one).
- Enter a PSA with the buyer of your old property.
- Depending on which document you parked under the EAT, the EAT will have to sign as the buyer or the seller. After which, the EAT transfers the property title to you. All these should be done within 180 days of the first property closing.
Final Thoughts
The reverse exchange option appears more desirable due to its numerous benefits. However, like all real estate investments, a reverse 1031 exchange also comes with risks like financial losses, legal ramifications, depreciation of assets, etcetera. To prevent some of these risks, consider consulting a knowledgeable real estate professional before making any legal or financial commitment.