For investors who want to defer taxes, 1031 exchanges remain an appealing option. Thanks to this like-kind exchange, you can swap one property for another without incurring tax liability. Since there is no sale, the IRS doesn’t levy capital gains taxes until you eventually make a constructive receipt. In this process, finding the replacement property comes after selling the relinquished one.
There is another option that changes the order of the transaction, and it’s called a reverse 1031 exchange. Through this variation, an investor can acquire a property before relinquishing their current one. Like a traditional swap, reverse exchanges are complex. Many investors who intend to try this may need help to increase the chances of a successful swap.
At Realized 1031, we’ve shared an insightful blog post as a guide for the reverse 1031 exchange process. We’ll discuss its difference from a traditional exchange, the rules to keep in mind, and more. Let’s dive in.
What Is a Reverse 1031 Exchange?
A traditional 1031 exchange is a process where an investor swaps a like-kind property for another. During the exchange, a qualified intermediary holds the proceeds to prevent a constructive receipt. There is a 180-day timeline for the entire transaction, with 45 days allotted for identifying possible replacement properties. Given this process, selling a property logically comes first before acquiring a new one.
Thankfully, the inverse can also happen. The IRS allowed reverse 1031 exchanges after establishing Rev. Proc. 2000-37, which provided safe harbor language for the new process.
A reverse 1031 exchange happens when an investor acquires a like-kind property before relinquishing their current real estate asset. There are a few scenarios where this approach is preferable, such as the investor wanting to purchase a promising asset immediately to avoid losing the opportunity. Given the reversal of a traditional like-kind exchange, this type of transaction is typically more complex. Understanding the rules and timelines is critical to increase the chances of a successful exchange.
What Is a Reverse 1031 Exchange?
While the steps in a reverse exchange are the inverse of a traditional one, one overarching rule remains: avoiding a constructive receipt. Here’s how investors can keep the transaction at arm’s length.
1. Identifying the Replacement Property
The first step to a reverse exchange is identifying the replacement asset. If you’re considering a reverse exchange, then you may have already done this step since the process is popular among investors who have an asset they wish to acquire.
2. Engage With a Qualified Intermediary or an Exchange Accommodator Titleholder
This step is critical since these entities help you avoid making a constructive receipt. The qualified intermediary will oversee the exchange process. On the other hand, the Exchange Accommodator Titleholder (EAT) holds the title of the property. If you own the title while also owning the relinquished property, then you’ll be disqualified from the tax deferral status.
3. Buy the Replacement Property
You may need to use financing for this step since you don’t yet have the proceeds from selling your current property. If you have enough funds, then financing may not be necessary.
4. Identify the Property to Relinquish
The 45-day rule in a traditional exchange also changes in a reverse exchange. Instead of identifying the acquired property, you identify the property you want to relinquish. Submit the details of the property to your qualified intermediary so that the IRS can assess whether it’s qualified or not.
5. Selling the Relinquished Property
Upon approval of the identified properties, the next step is selling them. You may need to work with a real estate broker to handle the sale, especially for commercial properties. After the sale, the qualified intermediary holds the proceeds of the property. It will then pay the lender if the financing was used for the replacement property. If you paid out of pocket, the qualified intermediary reimburses the remaining proceeds for certain exchange-related costs allowed under IRS rules. After the sale, the EAT transfers the title to you, the investor. This is the final step of the process.
Reverse 1031 Exchange Rules To Remember
There are three main safe harbor rules investors must keep in mind for reverse 1031 exchanges.
- EAT: Engaging with an exchange accommodator titleholder is critical during a reverse exchange. This entity holds the ownership of the acquired property so you don’t own the two properties at once. Direct ownership during the process creates a constructive receipt, which disqualifies you from the tax-deferred status.
- 45-Day Identification Period: The IRS also requires investors to adhere to the 45-day timeline. This begins upon the purchase of the acquired property.
- 180-Day Transaction Time Frame: Lastly, the IRS maintains the 180-day deadline for the entire transaction, which includes the 45-day identification period. This may present an issue for investors who are finding it difficult to find an asset that matches the value of the acquired property.
On a more general note, the other rules that apply to traditional exchanges also apply to reverse swaps. These include the equal or greater value requirements as well as the like-kind property requirement. For the latter, the IRS is quite flexible. As long as the acquired and relinquished properties are held for business or investment purposes, then they’re most likely qualified for an exchange. Given this rule, primary residences are not allowed in reverse exchanges.
Benefits of a Reverse 1031 Exchange
There are several advantages that make reverse exchanges appealing to some investors. These benefits include the following.
Secure a Desirable Property Immediately
The main reason why some investors prefer this process is because it allows them to acquire a promising real estate asset while enjoying the tax benefits. In a traditional exchange, you may waste precious time trying to sell the relinquished property in a competitive market. You could lose the desirable asset if another investor comes swooping in. A reverse exchange allows you to act quickly and lock in favorable deals.
No Pressure To Sell Quickly
Since you already acquired the desirable property, you’re not in a hurry to sell your current property — provided you stick to the 180-day timeline. Without the pressure of a quick sell, you have more negotiating power. Since you can be more picky with the offers, there’s a higher chance of higher profits from the relinquished property.
Avoid Market Fluctuations
Purchasing the acquired property immediately allows you to lock in the current selling price. In a traditional sale, you will need to wait at most 180 days before you finalize the sale, which exposes you to market fluctuations. In other words, the desirable property’s value may increase during the waiting period, leaving it beyond your reach.
No Rushed Decisions
The timeframe of a traditional sale may pressure investors into making hasty decisions, especially when choosing replacement properties. Since you’ve already done this step before the 180-day timeline begins in a reverse exchange, you can slow down and make more deliberate investment decisions.
Possible Challenges and Pitfalls
While reverse exchanges offer several advantages, the complexity may present a few challenges to investors. Here are some of the common disadvantages and pitfalls you should consider.
Potential Higher Costs
It’s not just the qualified intermediary you need to work with during a reverse exchange. You also need to engage with the EAT, which entails another expense. Add the fact that reverse exchanges are more complex, potentially requiring you to work with other professionals like tax lawyers and financial advisors. In general, expect the costs of this exchange to be higher than a traditional one.
Legal Complexity
As we mentioned, reverse exchanges are more legally complex than regular 1031 swaps. There are additional layers of documentation and legal oversight to comply with IRS safe harbor rules. The complexity requires a lot of research as well as engagements with other professionals to ensure compliance with IRS rules.
Possible Need for Financing
Acquiring the replacement property first often requires substantial upfront capital or bridge financing. Some investors may find it challenging to secure short-term loans, especially for high-value properties. Plus, these contracts may often involve higher interest rates.
Not Suitable for Investors With Limited Real Estate Portfolio
It’s ill-advised for investors to undergo a reverse exchange if they don’t have a wide enough real estate portfolio. Upon acquiring the new property, you will need to choose one (or several) assets that are of equal or greater value. If you don’t have enough assets to satisfy the requirement, you may need to take out another loan to match the asset’s value.
Strict IRS Deadlines
One more issue investors need to consider is the strict IRS timeframes. In a traditional sale, an investor may find it hard to identify and purchase a suitable replacement property. In a reverse exchange, you may face delays when selling the property. Selling commercial or investment property comes with its own challenges, which could prolong their stay on the market. You must sell the chosen property within the 180-day deadline or face disqualification from the exchange.
Understanding these challenges is critical for a successful reverse exchange. Since you know what to watch out for, you can make sensible decisions before and during the transaction.
Tips for a Successful Reverse 1031 Exchange
Given the complexity of a reverse exchange, we recommend following these best practices to increase the chances of a successful transaction.
1. Work With Qualified Experts
Engaging with an EAT and qualified intermediary is required. However, you shouldn’t limit yourself to just these professionals. We recommend working with accountants, tax lawyers, and financial advisers to gain as much guidance and resources as needed. With their help, you’ll gain a deeper understanding of the process and avoid making mistakes.
2. Plan Early
Another tip is to plan ahead of time, especially with regard to financing. Learn what you can about 1031 exchange loans and the requirements for qualification. Having a grasp of these prerequisites improves the chances of a quicker process.
3. Identify the Potential Relinquished Properties in Advance
Apart from learning loan qualification requirements, you should identify which of your assets will be exchanged for the new one. This step helps you address any issues with the relinquished asset beforehand and make it more attractive to potential buyers. That way, you can sell it within the 180-day deadline.
4. Ensure Documents Are in Order
Documenting every step of the transaction is critical to ensure adherence to IRS guidelines. In addition, having the required documents as well as other supporting papers may help protect you from audits.
Wrapping Up: How Does a Reverse 1031 Exchange Work
Investors who already have an asset they want to acquire will find reverse 1031 exchanges as a viable option. Aside from the tax deferral benefits, this process helps you secure a promising asset without having to sell your current property first.
The reverse 1031 exchange process can be complex, requiring you to work with both a qualified intermediary and an EAT. As such, careful preparation and understanding of the IRS rules are necessary to ensure a smooth transaction and maintain your tax-deferred status.
For additional guidance regarding reverse exchanges, Realized 1031 can help. We’re your trusted professionals who can provide advice and solutions for this type of exchange. Contact us today to schedule an appointment.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.irs.gov/pub/irs-news/fs-08-18.pdf
https://www.irs.gov/pub/irs-drop/rp-00-37.pdf
https://www.investopedia.com/terms/r/reverse-exchange.asp
https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/
