A reverse 1031 exchange is a tax-deferred transaction in which you purchase a property, park it with a qualified intermediary, and sell a property you own. The capital gains tax the sale would typically trigger is rolled into the new property.
A reverse 1031 exchange can allow you to jump on a good deal immediately—before you’ve sold another holding in your portfolio to pay for it. However, these transactions can be deeply complicated. You’ll need the help of an expert in reverse 1031 exchanges to make them work.
What Is a Traditional 1031 Exchange?
Properties you own for business purposes (such as apartment buildings, office parks, and rental homes) are subject to tax when you sell them. As experts explain, capital gains tax could be considered double taxes on corporate income. After all, you’ve probably paid income tax on the money you invest. A 1031 exchange could help.
The IRS allows taxpayers to postpone the taxes they owe if they reinvest into another business property through a like-kind exchange. Traditionally, that means selling a property, identifying another, and buying that property in a dependent arrangement. A qualified intermediary holds the proceeds of the sale and releases them for the purchase.
A transaction like this allows you to roll your tax obligations into the new property. If you never sell that replacement, the bill never comes due. If you do want to sell that property, you could use another exchange to roll the taxes forward again.
What Is a Reverse 1031 Exchange?
A reverse 1031 exchange comes with the same potential benefits as its traditional counterpart. However, one subtle difference separates them.
In a reverse 1031 exchange, you purchase a property first. You may have an asset in mind to sell, but you haven’t done so yet. Instead, you’ve taken the leap to purchase first and sell last.
As the IRS explains, a reverse 1031 exchange involves an expert (an exchange accommodation titleholder—or EAT) who holds the property for no more than 180 days. During this time, you sell your property and complete the exchange via your EAT.
What Properties Can Be Involved in a Reverse 1031 Exchange?
A reverse 1031 exchange is also known as a “like-kind exchange.” Per rules from the IRS, both properties must be similar enough to be considered like-kind.
That means both properties have to be used for a business or investment. If the asset you want to buy or sell is primarily for personal use (like your family home that you live in all the time), it’s typically not eligible for these sorts of transactions.
Like-kind properties don’t have to be of the same nature, class, or character. For IRS purposes, it doesn’t matter if the assets are exactly the same. Your transactions could involve things like an office park for a retail mall or an apartment building for a high-rise office building.
However, there are some exceptions. For example, you can’t include properties that are in separate countries.
The two properties should also be of at least similar value. Ideally, the asset you’re purchasing should be worth more than the one you’re selling. Otherwise, you could be taxed on the monetary difference between the two. It’s worth the effort to ensure you are choosing a good new property for the exchange.
How Does a Reverse 1031 Exchange Work?
Let’s walk through the steps involved in these complex transactions. Remember that you don’t have to handle this process alone. In fact, it’s impossible to complete a 1031 exchange without an outsider.
However, know that these sales processes can be lengthy and involve several steps. Here’s what to expect:
Step 1: Identify an EAT
An exchange accommodator titleholder (EAT) is a crucial part of the reverse 1031 exchange process. This entity will acquire and hold your replacement property under a qualified exchange accommodation arrangement (QEAA). You must make these deals within five days of the EAT taking the property you’ve purchased.
It’s best to identify this partner before you get started since the time frames are so tight. There isn’t wiggle room if you make a mistake.
Step 2: Purchase & Park
To get all of the tax benefits associated with a 1031 exchange, you can’t hold titles to both properties at once. Instead, as the IRS explains, investors “park” the property until the sale of the second property is complete.
While your new property is parked, you’re still responsible for things like maintenance, insurance, and loan repayments. However, the EAT holds the property for you and allows the exchange to move forward.
Step 3: Identify the Other Property
A 1031 exchange is a transaction that involves two properties. The purchase and the sale are mutually dependent. Before you enter a reverse 1031 exchange, think about what asset you’d like to sell.
After your purchase closes, you have just 45 days to tell your EAT about the other property involved in the exchange. You must identify the other property clearly with details like its address, formal name, and current value. That identification must be delivered in writing by the deadline.
Step 4: Sell the Other Property
Your replacement property must be sold and the transaction must be completed within 180 days of the purchase of the other. This deadline can be tight in some markets, but that deadline isn’t flexible. If you don’t think you can finish the sale on time, this isn’t the right option for you.
When the sale is complete, the proceeds will go directly to your EAT. If you used a loan to purchase the property, those funds could help to pay off your loan.
Step 5: Complete the Exchange
At this stage, the EAT will transfer the property's title to you, and your exchange process is complete.
Step 6: Notify the IRS
You’ll need to report your exchange in your tax documents for that year, and you should track your basis in the new property. Your taxes haven’t disappeared, and if you sell, they could come due. Work with an accountant to keep your paperwork in check.
Common Reverse 1031 Exchange Challenges
While a reverse 1031 exchange can deliver plenty of benefits, these transactions are very complex. Sometimes, the challenges are big enough that they make this approach less desirable. Here are common problems people face:
Securing a Loan
In a reverse 1031 exchange, you purchase a property before the other is sold. Ideally, you’ll have enough money on hand to purchase the asset outright. If you don’t, you may need a loan. This can be challenging.
A lender would need to list the EAT (not you) as the holder of the asset’s title. Some banks and mortgage companies aren’t comfortable with this arrangement and won’t execute loans like this.
You may also have fees involved with the transaction, the closing, inspections, and more. You should have funds on hand for these costs too.
Dealing With Taxes
In a reverse 1031 exchange, the new asset’s title changes hands several times. It moves from the owner to your EAT and back to you. In some cases, those switches come with transfer taxes. It’s important to research how your state handles these transactions and the associated costs.
Meeting the Deadlines
Some real estate markets are challenging. You may be eager to purchase a property that’s hot and upcoming, but it could be difficult to sell the asset in your portfolio. Unfortunately, you can’t swap out the 1031 exchange deadlines or ask for an extension.
If you can’t sell the property by the 180-day deadline, your potential tax benefits could disappear, and you could be the proud owner of more properties than you intended. Careful planning and some expert guidance can help you to avoid an undesirable situation.
Get Help With Your Reverse 1031 Exchange
A reverse 1031 exchange could help you seize an opportunity before it slips away. However, you need someone on your side that understands the rules and can keep you on track.
At 1031 Pros, we’ve helped investors just like you through these challenging transactions. We can park your property safely and legally, and we can ensure that your sale happens smoothly. Talk to us to find out more about how we can help.
References
An Overview of Capital Gains Taxes. (April 2019). Tax Foundation.
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
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