In a traditional 1031 exchange, you sell one property, identify a replacement, and complete the purchase. The two transactions are deeply connected, but the sale of your original property comes first.
A reverse 1031 exchange is very different. In a reverse 1031 exchange, you buy the replacement property first and then sell the original.
Understanding the reverse 1031 exchange rules is crucial. If you make a mistake, the transaction could trigger a large tax bill that wipes your profits away. It’s worth it to have a professional guide you through this delicate process.
What Is a Reverse 1031 Exchange?
Before we outline the reverse 1031 exchange rules you should know, let’s explain what these transactions are and why they’re advantageous.
In a traditional real estate transaction, the sale of an investment property prompts a tax bill within the calendar year. A 1031 exchange allows you to defer that bill. Essentially, you roll the fees into your new property. When you sell that new property, the money is due. However, if you keep it until your death, your heirs won’t be asked to pay that bill.
Exchanges are dependent transactions, meaning that the purchase and the sale are two parts of one whole. Typically, an investor hires an intermediary to take possession of the funds at the end of a sale and facilitate the transaction of a replacement property with those funds.
A reverse exchange, per the IRS, involves buying a replacement property through a hired titleholder who will keep it (or “park” it) for no more than 180 days while the original property is closed.
Essentially, a reverse 1031 exchange still involves swapping one property for another. However, in these transactions, the purchase of the replacement comes before the sale of the original.
5 Reverse 1031 Exchange Rules You Should Know
You’ve found the perfect investment and want to grab it before it’s gone. A reverse 1031 exchange could be just right for you. Ensure that your transaction meets all of the reverse 1031 exchange rules listed here.
1. You Can’t Hold Both Properties at Once
Per strict IRS rules, you can’t be the official owner of both properties at the same time. If you touch the titles of both properties (or the funds from either transaction), you could face tax penalties.
The IRS provides a “safe harbor” for reverse 1031 exchanges. The investor must use an exchange accommodator titleholder (EAT) who will park the new property until the old one is sold. With this arrangement, the transactions move forward without triggering tax bills. If you skip this step, you’re violating the criteria for this exchange.
2. The Replacement Property Must Be Like Kind
Two properties are involved in any 1031 exchange. The IRS requires these properties to be “like kind.”
The IRS doesn’t require the properties to be of the same quality. You can trade a run-down investment for a shiny new version. Similarly, they don’t have to be in the same class. You can trade an apartment building for an office complex or a commercial building for a farm.
The IRS says most real estate will be like kind to other real estate. However, both properties must be in the same country. You can’t sell a property in the U.S. and purchase a property in Scotland.
3. Both Properties Must Be Investments
IRS rules specify that properties in 1031 exchanges must be used for business or investments. Typically, that means you can’t use a property like an office park to purchase the dream home your family has always longed for.
These rules are designed to allow investors to keep the profits from their hard work. They aren’t made to help people get out of a business investment to buy a personal property.
4. The Replacement Property Must Be Valuable
The tax-deferment benefits of a 1031 exchange evaporate if you don’t roll the entirety of your profits into a new investment. In other words, you can’t use an exchange to pull money out of one building and buy something much less expensive.
IRS rules don’t require you to involve two investments of exactly the same value. You can buy something that’s more expensive and take out a loan to fill your funding gap. Similarly, you can buy two less expensive products with the proceeds of one sale. However, your exchange should not trigger any kind of payout or check to you. All the money you might make should go into something new. Consult an expert to ensure your sale and purchase add up correctly.
5. You Must Meet Tight Deadlines
All exchanges come with very strict time frames set by the IRS, and there isn’t wiggle room here. Hiring an expert is smart. Companies with robust reverse 1031 exchange services can help you stay on schedule and ensure you complete each step properly.
These are the two deadlines you must meet:
45 days after the purchase: You must give your EAT a document that clearly identifies the property (or properties) you’re selling as part of the exchange. That paperwork must be signed by you.
180 days after the purchase: The sale of the property must be complete.
How Does a 1031 Reverse Exchange Work?
All exchanges are complicated, intricate transactions. It’s always smart to hire someone to guide you through the process and ensure you handle each step properly. However, this overview can help you understand what’s typically involved.
Step 1: Hire Help
You’ll need someone to accept the property you’ve purchased until the transaction is complete. That entity, your EAT, will park the property for you under a legal framework called a Qualified Exchange Accommodation Agreement (QEAA).
In most cases, you’ll also need a qualified intermediary to complete an exchange. This entity will handle steps like delivering documents to the title company, holding any funds from the transaction, coordinating the transfer of funds at the close of the sale, and releasing funds as needed.
Step 2: Park Your Property
With the legal framework set up and ready to go, you can purchase the replacement property and transfer the title to your EAT. In a typical arrangement, you can rent the property from the EAT and run your business as usual. You’re also responsible for any loan payments and financial arrangements you made to purchase the property. However, you’re not quite the legal holder of the item quite yet.
It's worth repeating that these arrangements can be complicated. Ensure that you read the QEAA carefully, so you understand your rights and responsibilities as the transaction moves forward.
Step 3: Identify the Replacement
If you’re a large investor, you may have more than one property in play in this 1031 reverse exchange. Within 45 days of the purchase of the new property, you must give your qualified intermediary who is handling the exchange a written document that outlines exactly what you’re selling.
This document must clearly outline what’s for sale. That means you must give its address, physical description, and any other information that defines the scope of the property. Don’t skimp on details here. That document must be signed too.
Step 4: Sell the Property
Once you’ve identified the property, it’s time to sell it. The deadline is tight here, as the sale must be completed within 180 days of the purchase.
While this time frame might be easy to meet in a tight market with plenty of competition, it can be more difficult in lax markets. Watch the calendar closely and make adjustments as needed to ensure the sale happens on time. If you miss this deadline, you can’t fix the issue later.
Step 5: Complete the Exchange
With both transactions complete, your EAT and qualified intermediary wind down the sale and transfer the title of the new property to you. Plenty of paperwork is involved at this step, and it can be complicated. However, if you met all of the reverse 1031 exchange rules, you shouldn’t face a big tax bill.
Get Help With Reverse 1031 Exchange Rules
At 1031 Pros, we know that reverse exchanges can be much more complicated (and challenging) than standard exchanges. However, we also know that these transactions can have big benefits. Far too many investors let the perfect property slip away because they don’t have the funds to buy it yet. A reverse exchange can change all that and make this transaction feasible for your situation.
We have plenty of experience as qualified intermediaries in reverse exchanges. We’d like to help you. Contact us to get started today.
References
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
Rev. Proc. 2000-37. Internal Revenue Service.
Exchanges Under Code Section 1031. American Bar Association.
Like-Kind Exchanges - Real Estate Tax Tips. Internal Revenue Service.
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