You find a property that you really want to purchase, but you know you have to move quickly to take advantage of the investment opportunity. The problem is you haven’t sold your existing property yet. A Reverse 1031 Exchange might be the answer and could save you thousands of dollars in capital gains taxes.
It’s a competitive market for investors looking to acquire solid, like‐kind replacement properties for tax‐deferred 1031 Exchanges ‐‐ whether it’s an apartment building, medical office building, retail center or even a single‐family home. So if you find a property that’s just too good to pass up – but you haven’t sold your current investment property yet – a Reverse 1031 Exchange
A Reverse Exchange might be your best bet. It offers you some flexibility in today’s fast‐paced real estate market.
What Exactly is a Reverse Exchange?
A reverse exchange allows investors to acquire the new property (or replacement property) first, and then sell their existing (or relinquished) property. So in essence, it’s the “buy‐first, sell‐later” method. It takes some of the pressure off, because you can close on the purchase of your replacement property right away, and then worry about marketing and selling your existing property later.
“A standard reverse exchange involves a situation that somebody says, ‘OK, I found a piece of property I want to buy. I haven’t either listed my other property for sale or I think it’s going to take a long time for me to get that property sold, and ultimately close, and it’s not going to happen until after the closing of the purchase,’” explains Steven Rosansky, senior director of exchanges for Peak 1031 Exchange Inc. “So for that reason, I would do the reverse. The reverse gets them a vehicle to actually lock down their acquisition property before they sell.”
It’s Basically a 1031 Exchange, But ‘Backwards’
A standard 1031 Exchange is where investors sell a property, reinvest proceeds from that property and then buy a replacement property.
“The same rules apply for a reverse exchange that apply for the 1031 Exchange ‐ it’s just kind of a backwards thing... You’re just doing it in an opposite way,” says Bonnie Lee, owner of Taxpertise in Sonoma, Calif. “Instead of saying, ‘I want out of this building and I want to get a new one, let me go get that one over there and do a 1031’ ‐‐ this one is, “Oh, I saw this building. I gotta have it. Now which one am I going to give up to get it so I don’t have to pay taxes.’”(By doing a reverse, you’re able to defer any capital gains taxes).
But There are Strict Rules to Follow
Since you haven’t sold your property yet, you can’t buy the new property in your name because it won’t qualify to be exchanged with your current property. In other words, the IRS says you can’t have both properties in your name at the same time.
What’s the Solution? “The first thing to do is talk to your lender and also find an accommodator or qualified intermediary,” says Nikki Reagan, a Realtor in Bullhead City, Ariz. “From a Realtor’s perspective, I get the ball started and it pretty much becomes the lender and accommodator or intermediary to get it closed.”
The new property must be purchased through a qualified intermediary, also known as an exchange accommodator. Many title companies today have their own accommodators. Typically, the qualified intermediary or accommodator will create a separate limited liability company (LLC) that temporarily takes title to the replacement property until your existing property is sold. So in essence, they hold or “park” the property in the LLC until you close on the sale of your current property.
How Do You Finance the Purchase of the Replacement Property?
Your main challenge with a reverse exchange might be the financing. If you have the available cash, then it’s pretty straightforward where you loan the funds to your accommodator or qualified intermediary under a separate loan agreement.
However, if you need an outside loan, that can be more complicated. Many lenders are concerned with the structure – and potential risk ‐‐ of this type of transaction. Although increasingly, more lenders are coming around and willing to give the “parking or holding” entity a loan secured by the property, but also will likely require a guarantee from the investor/buyer. Shop around for a lender to find one willing to work with you on your transaction.
“We try and see if there’s a way around doing a reverse exchange because it’s more expensive, and generally, they [the buyers]need financing and the lender has to be OK with giving them the financing given the fact they we’re going to go on the title. That’s a potential obstacle,” Rosansky says.
Remember the Qualified Intermediary (QI) Actually Acquires the property
In a reverse exchange, the qualified intermediary purchases the replacement property on behalf of the buyer and actually takes title to the property in their name. That’s important for the QI because there can be some issues being in the chain of title. It’s also important for the buyer to consider the impact of transfer taxes and title fees ‐‐ all of which a good QI should be able to identify for the buyer.
When Does the Clock Start?
Within 45 days of purchasing the “parked” (or replacement) property, you have to identify a property to sell. You must sell that existing property within 180 days of the date that the replacement property was purchased.
Rosansky says neither timeframe is usually a concern.
“The 45 days is typically never a problem because they already generally know what property they’re selling, so they just have to identify that property,” he says. “They then market their other property for sale and have 180 days to sell that property. But in all fairness, in today’s market selling a property and having six months to do so is generally not an issue.”
Once you sell your existing property, you can transfer the title of the replacement property into your name and the reverse is complete.
Weighing the Costs
The fees associated with a reverse 1031 exchange are considerably higher than a standard 1031 Exchange, because it’s a more complex transaction. If these fees outweigh your tax liability, you may want to consider a standard 1031 Exchange, or perhaps, keeping your current property. But it’s always good to know you have options.