In a 1031 Exchange, a taxpayer defers capital gains taxes on the sale of real estate by exchanging the proceeds from the sale into a “like-kind” property of equal or greater value. The transaction derives its name from Section 1031 of the Internal Revenue Code. In addition to the tax on your capital gain, you may need to pay a state capital gains tax, depreciation recapture, and NIIT (Net Income Investment Tax) when you sell investment property for a price that is greater than your basis in the property. Instead of just selling, by completing a 1031 exchange, you can potentially defer each of these obligations.
In a traditional 1031 exchange, the investor sells the identified property first but must ensure that they do not take possession of the proceeds from the sale. For that reason, engaging in a 1031 transaction requires using a Qualified Intermediary throughout the process. The QI (sometimes called an exchange accommodator) is an essential participant in the exchange operation. This person (or company) maintains access to the proceeds from the sale of the relinquished property, completes the paperwork related to the formal identification of the replacement property or properties, and administers the purchase of the selected assets.
What if I Find the Replacement Property First?
Suppose the investor identifies the potential replacement property before selling the asset that is to be designated as the relinquished property in the 1031 exchange. In that case, the transaction can proceed as a reverse exchange. In some ways, it can ease the pressure associated with a 1031 transaction because you have the replacement property lined up in advance.
But there are other potential complications. First, as the investor cannot be the buyer, you must have the QI facilitate the purchase and hold the property at arm's length (perhaps in a limited liability company) until you have sold the property you identify as the relinquished asset). If you don't sell that asset in the time allowed, the transaction won't qualify. The same limits still apply to the exchange as if you sold the property before buying the replacement, just in reverse. Second, within 45 days of the closing on the new property, you must identify the property (or properties) you plan to sell and then complete the transaction within 180 days, inclusive. In a fast-paced real estate market, that isn't as much of a concern, but it can be an issue if demand is down or the property that isn't attractive for some reason.
What Else Can Complicate The Reverse 1031?
If you buy the new (replacement) property with cash, the exchange will probably be straightforward. You loan the money to your QI to make the purchase and get paid back when you take control of the asset after the process is complete. However, a reverse 1031 can get sticky if you need to finance the acquisition. The lender needs to be willing to finance the property in a complicated structure and may require additional signers or guarantees.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits.
