The Lowdown on a Reverse 1031 Exchange
You’re probably familiar with a traditional 1031 exchange. That’s when you sell one investment property and buy another within a certain period of time, and defer paying tax on your capital gains.
But there’s also a less-known type of tax-deferred exchange called a Reverse 1031 that savvy investors use to optimize their portfolios to be tax efficient. What follows is an analysis of the reverse 1031 exchange and how to use this little-known type of tax-deferred exchange to grow your real estate business. This even works when the competition for good investment properties is high.
Types of 1031 Tax Deferred Exchanges
There are three main types of 1031 tax-deferred exchanges:
- Delayed 1031 exchange
- Build-to-suit 1031 exchange
- Reverse 1031 exchange
Most investors are familiar with a delayed 1031 exchange.
The like-kind replacement property must be identified within 45 days of closing escrow on the relinquished property (the property being sold), and escrow must close on the replacement property within 180 days of the relinquished property’s close of escrow.
In Like-Kind Exchanges – Real Estate Tax Tips, the IRS defines “like-kind” property as real estate that is used for business or investment purposes. For example, an investor could relinquish an apartment building and replace it with an office building, or relinquish a small shopping center and replace it with a portfolio of single-family homes.
How to do a Reverse 1031 Tax Deferred Exchange
As the name suggests, a reverse 1031 tax-deferred exchange works opposite from the traditional delayed exchange. In a reverse 1031 exchange, an investor buys the replacement property first, then relinquishes or sells the current property. The 45-day and 180-day timelines still apply, except that they work in reverse.
To conduct a reverse 1031 exchange, investors use the services of an Exchange Accommodation Titleholder (EAT) and a Qualified Intermediary (QI). That’s because the investor can not actually take title to the replacement property until the current property is relinquished.
Who can be a QI? Good question. Your accountant, lawyer, or real estate agent are all examples of QIs. You cannot be your own QI in a 1031 transaction.
Steps in a reverse 1031 tax-deferred exchange
- Identify the replacement property to purchase.
- Sign an agreement with the EAT to take title and possession of the replacement property until the relinquished property is sold.
- Close on the purchase of the replacement property with the EAT taking title and actual possession.
- Identify the relinquished property within 45 days of closing on the purchase of the replacement property.
- Execute the purchase agreement with the buyer of the relinquished property, naming the EAT as the seller of the relinquished property.
- Sign an agreement with the QI, giving the QI the authorization to transfer title of the relinquished property to the buyer and authorizing the QI to take title of the replacement property from the EAT.
- Close on the sale of the relinquished property within 180 days of the purchase of the replacement property, with sales proceeds transferred directly to the QI.
- QI uses the sales proceeds to acquire the replacement property from the EAT, then transfers the replacement property to the investor.
Benefits of a Reverse 1031 Exchange
To be sure, the process for conducting a reverse 1031 exchange is more complicated than a traditional delayed tax-deferred exchange. But a reverse 1031 tax-deferred exchange can be worth the extra effort for some real estate investors:
In a reverse 1031 exchange, the 180-day countdown from the sale of the relinquished property hasn’t begun. By purchasing the replacement property first, an investor has more time to analyze alternative investments and negotiate the best possible deal.
Good deals are becoming increasingly hard to find. Once a replacement property is located, an investor can seize that opportunity by locking down the perfect replacement property at the right price. Then when the deal closes, the relinquished property is listed for sale.
A reverse 1031 tax-deferred exchange also gives an investor more control over the terms and conditions of the sale of the relinquished property. Price, contract terms, and contingencies can be negotiated with the buyer to ensure the 180-day timeline for completing a reverse 1031 exchange is successfully met.
Timelines with a Reverse 1031 Exchange
The timelines to follow for a reverse 1031 exchange are the same for other types of tax-deferred exchanges, except they work in the opposite order:
- 45-day limit: Identify the relinquished property being sold within 45 days of the close of escrow of the replacement property.
- 180-day limit: Close on the sale of the relinquished property within 180 days of the purchase of the replacement property.
Ways to Structure a Reverse 1031
There are two ways to structure a reverse 1031 exchange, depending on the unique needs of the real estate investor.
An “Exchange Last” reverse 1031 exchange follows the steps we’ve just described. The EAT takes title and possession of the replacement property, with the QI acting as the seller of the relinquished property.
After the sale of the relinquished property occurs within the 180-day timeline, sales proceeds from the relinquished property are used to purchase the replacement property from the EAT. Then, the title of the replacement property transfers to the investor.
An “Exchange First” reverse 1031 exchange occurs when the EAT (Exchange Accommodation Titleholder) purchases and takes title to the relinquished property before the replacement property is purchased.
Funds for the purchase are provided by the investor, and the property is leased back from the EAT, allowing the investor to effectively retain control of the relinquished property until a replacement property is found within the 180-day timeline.
A reverse 1031 tax-deferred exchange is more complicated than a traditional delayed tax-deferred exchange, but can well be worth the extra steps in an extremely competitive real estate market.
Investors who have large amounts of equity in income-producing real estate benefit by using a reverse exchange to seize new investment opportunities while retaining more control over the sale of the relinquished property to ensure that every timeline is met.