Timing often plays an important role in the acquisition of commercial real estate, especially in competitive markets where properties may receive multiple bid offers from a pool of eager investors.
Timing also plays an important role in the 1031 exchange process. Landlords who sell an investment property have a short window to identify and close on like-kind replacement assets. Investors wondering if they can purchase a replacement investment property as part of a 1031 exchange prior to disposing of their original property can rest assured that the process is perfectly acceptable – and it also can help alleviate the deadline stress that may arise during a standard exchange.
Here’s how the process works.
Acquiring an investment property that will become the replacement property in a 1031 exchange prior to disposing of your original asset is called a reverse exchange. This type of exchange differs from a standard delayed exchange, where you would first sell your investment property and then roll the sale proceeds over into a like-kind property in order to defer taxes on any realized capital gains.
If you plan on doing a reverse exchange, there are some super important rules to which you must adhere, or you run the risk of having your exchange disqualified by the Internal Revenue Service. Foremost among them is that all sale proceeds from the disposition of your relinquished property must be held in a qualified escrow account established by a third-party exchange facilitator, also known as a qualified intermediary. You cannot take receipt of sale proceeds at any point during the exchange process. If you do, it will be considered a straight sale in the eyes of the IRS and you’ll be responsible for any tax liabilities generated from the sale.
The first step in a reverse exchange is to engage the services of a qualified intermediary prior to purchasing the asset you plan to use as a replacement property in your 1031 exchange. After purchasing the replacement asset, the QA will become the exchange accommodation titleholder (EAT) while you work towards divesting your relinquished property. This title holding or parking provision is what gives you safe harbor during the exchange process and helps ensure your exchange remains compliant with IRS guidelines.
The exchange accommodator will create a single-member LLC that becomes the legal titleholder of the replacement asset. During the parking period, this entity is responsible for making any loan payments, as well as insurance, taxes, and operating expenses, on the property. Rental payments made by tenants, meanwhile, flow through to the LLC. If you need to make any improvements to the property, you can contribute cash directly to the EAT for renovations without incurring any type of penalty.
The timelines mentioned in the opening of this article come into play as soon as the acquisition of your replacement asset is finalized. In a standard deferred exchange, you have 45 days after the close of sale on your relinquished asset to formally identify a like-kind replacement, and 180 days to close on your target property. In a reverse exchange, your original asset is identified as the relinquished property, and you have 180 days after closing on the replacement property to divest your original property. If you fail to find a buyer and close the sale in that timeframe, your exchange will fail and the title to the replacement property will be conveyed to you.
A few other key provisions apply to reverse exchanges. The replacement property has to be of equal or greater value as the relinquished property, and debt must align as well – you can’t use the exchange process to improve your financial position. Both assets also must be held for investment purposes.
For investors with ample access to cash or credit, completing a reverse exchange may be a good strategy to quickly acquire a coveted investment property. Reverse exchanges bring increased execution risk, though – if for some reason you can’t sell your original property within 180 days after finalizing the purchase of your target property, your exchange will fail, and you’ll hold title to two properties. The only way to defer capital gains taxes after selling your original property in a failed reverse exchange is to complete a standard deferred exchange, but you’ll still own two properties.
Planning, timing, and execution are of utmost importance in a reverse exchange where you buy a property and then do a 1031 exchange. Working with a qualified intermediary and taxation professional who is well-versed in 1031 exchange laws and regulations can potentially help you avoid any complications that may arise during a reverse exchange.