There are a few different ways to conduct 1031 exchanges, potentially deferring capital gains taxes. Named after Section 1031 of the Internal Revenue Code, these exchanges allow investors to reinvest the proceeds from a property sale into a like-kind asset, maintaining their investment without incurring any immediate tax liability.
The traditional “forward” exchange is one of the more commonly used approaches, but other structures—such as the reverse exchange—may also be applicable depending on the investor’s circumstances. Each option comes with its own set of timing, logistical, and financial considerations.
Below, Realized 1031 has shared a guide discussing the difference between the two to answer these questions. Keep reading to learn more.
What Is a Like-Kind Forward Exchange?
When we think of the traditional 1031 exchange, we’re typically thinking of the forward exchange. This variation is also called the delayed exchange since there is a time delay between selling the relinquished property and acquiring the replacement property. Here’s how the process typically works.
- You sell your replacement property to a willing buyer. This asset must have been held for investment or business use.
- The proceeds are held in escrow by your qualified intermediary.
- Immediately after closing, the 180-day timeline begins. You have 45 days to identify replacement properties, which must be like-kind with the relinquished asset.
- After identifying prospective assets, you negotiate with sellers and buy the one that fits your investment needs.
- The qualified intermediary transfers the funds to the seller, and you close the sale. Since no constructive receipt was made, the capital gains from the relinquished property will not be taxed until a triggering event happens.
What Is a Like-kind Reverse Exchange?
The reverse exchange flips the script. Instead of selling the relinquished property before acquiring the replacement one, you first purchase the latter before getting rid of your current asset. This structure is particularly beneficial when a desirable property becomes available unexpectedly or when the investor doesn’t want to risk being left without a replacement after selling. Here’s how the reverse exchange typically works.
- You acquire the replacement property through an Exchange Accommodation Titleholder (EAT). Engaging with an EAT is necessary because you cannot own the title to both properties at the same time.
- After closing the purchase, you have 45 days to identify the relinquished property that has similar value to the replacement asset.
- The remainder of the 180 days must be dedicated to selling the relinquished asset. After that, the exchange is completed.
Pros and Cons of 1031 Forward Exchange
A 1031 forward exchange is commonly used and relatively straightforward, which is why many real estate professionals and qualified intermediaries are well-versed in its execution. Below are some of the key pros and cons when considering this strategy:
Pros
- Familiar Structure: The delayed exchange is the standard transaction. There’s no need to secure large capital to acquire the replacement property since you have the proceeds from the sale of the relinquished asset.
- Broad Industry Familiarity: Many qualified intermediaries and other 1031 professionals are familiar with the forward exchange, and they can assist in navigating the process in accordance with IRS guidelines.
- More Time for Research: The structure also gives investors some time to research the market and identify suitable replacement properties after closing the initial sale.
Cons
- Strict Timelines: The 45-day and 180-day windows may be too short for acquiring a suitable replacement property, which could result in disqualification from the tax-deferral benefits.
- Settling for Less-than-ideal Replacement Properties: You may feel pressure to acquire a replacement property that doesn’t fit your goals just to finish within the deadline.
Pros and Cons of 1031 Reverse Exchange
Some investors consider a reverse exchange when they wish to secure a replacement property before selling their current asset. However, this type of exchange involves additional complexity and regulatory requirements that may be more challenging to manage.
Pros
- May Be Suited for Competitive Markets: In hot markets where desirable properties become available quickly, the reverse exchange structure allows investors to acquire a replacement property without needing to complete a prior sale.
- Potential for Greater Timing Flexibility: You can avoid being temporarily left out of the market (since you cannot access your capital), which can happen with delayed exchanges.
- Different Timing Considerations: You can reduce the stress of 45-day or 180-day timelines since you already have the replacement property. Deadlines will also matter less if you already have other properties to sell.
Cons
- Requires High Upfront Capital: Since you don’t have proceeds from the relinquished property sale, you’ll need to find resources elsewhere to purchase the replacement property.
- Increased Complexity and Compliance Burden: The use of an EAT adds administrative and legal fees. Plus, the IRS set other rules through Revenue Ruling 2000-37 that you must follow to maintain your tax-deferred status.
1031 Reverse Exchange vs. Forward Exchange: Key Differences Outlined
Below are several core distinctions between forward and reverse 1031 exchanges:
Sequence of Transactions
- Forward: You sell the relinquished property before acquiring the replacement asset.
- Reverse: You acquire the replacement property before selling the relinquished asset.
Capital Requirements
- Forward: Generally, the replacement property is purchased using proceeds from the sale of the relinquished asset, which may reduce the need for upfront capital..
- Reverse: You will need to secure funding to access the replacement property.
Timing Flexibility
- Forward: Offers more flexibility in identifying what to buy.
- Reverse: Allows more control over the timing of the sale.
Final Thoughts: Like-Kind Forward Exchange vs. Like-Kind Reverse Exchange
Analyzing the pros and cons of forward and delayed exchanges is important for investors who are unsure which route to take. Each option may be appropriate for different scenarios, though traditional exchanges are generally the more commonly used strategy. For investors operating in competitive markets who prefer to secure a replacement property before it becomes unavailable, the reverse exchange may be more suitable. Whichever the case, make sure to consult with financial advisors or 1031 exchange experts to get in-depth insight into both strategies.
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.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.irs.gov/pub/irs-drop/rp-00-37.pdf
