What You Need to Know About a Reverse 1031 Exchange

A 1031 tax-deferred exchange provides a wide range of potential benefits. By strategically conducting an exchange, you can scale up, diversify your real estate portfolio by type of property and geography, and still defer the payment of capital gains tax.

Most tax-deferred exchanges involve selling one property before buying another. However, a growing number of investors are using a reverse 1031 exchange to take advantage of the opportunities surfacing in today’s real estate markets.

In this article we’ll discuss how a reverse 1031 tax-deferred exchange works, and how you can use a reverse exchange to grab good deals and grow your real estate business.

Main Types of 1031 Exchanges

Section 1031 of the Internal Revenue Code (IRC) requires that investment real estate used in a 1031 exchange be "like-kind" based on the characteristics of the property, not the quality or asset class of the property. 

For example, a single rental house property can be exchanged for multiple rentals, or commercial property can be relinquished and replaced with a portfolio of single-family and multi-family rentals.

The flexible way that the IRS defines like-kind property also allows for a wide range of real estate that can be relinquished and replaced. There are also different ways to conduct a 1031 tax-deferred exchange that allow you to benefit from deferring the payment of capital gains tax.

1. Delayed 1031 exchange

A delayed exchange is the most common type of tax-deferred 1031 exchange and the one investors are most familiar with. Prior to 1979 an exchange had to occur at the same time, with the escrows for the relinquished property being sold and the replacement property being purchased taking place simultaneously. 

Bringing buyers and sellers to the closing table at the same time created obvious problems and the potential for last-minute conflicts. So, in 1979 the rule was changed to allow for non-simultaneous exchanges to take place over a 180 day period, which is how the ‘delayed’ 1031 exchange found its name.

A delayed 1031 exchange follows three steps:

1. Close on the sale of the relinquished property with a Qualified Intermediary (QI) accepting the sales proceeds
2. Identify one or more replacement properties within 45 days of the closing of the sale of the relinquished property
3. Close on the purchase of the replacement property (or properties) within 180 days of the closing of the sale of the relinquished property

A build-to-suit tax-deferred exchange is used in situations where the replacement property is being renovated or is new construction. For example, a single-family investor may identify a spec home being built on a vacant lot as the replacement property.

The same 180-day time frame applies to build-to-suit 1031 exchanges. Also, all of the constructions and improvements must be completed within this 180-day window to be included in the exchange. 

This means that the value of any remaining work – such as installing flooring or mechanical systems such as the HVAC – must be completed prior to closing. Any improvements completed outside of the 180-day period are treated as personal property by the IRS and do not qualify as part of the tax-deferred exchange.

3. Reverse 1031 exchange

As the name suggests, a reverse 1031 tax-deferred exchange follows the opposite process that a delayed 1031 exchange does.

In a reverse exchange you acquire the replacement property before the relinquished property is sold. However, you can’t take actual possession of the replacement property until the entire 1031 transaction is completed. Instead, the new property must be held by your Exchange Accommodation Titleholder (EAT) until the relinquished property is sold.

Why Do a Reverse 1031 Exchange?

In many real estate markets today, there are investment opportunities that were nearly impossible to find less than one year ago. By conducting a reverse 1031 exchange you can seize the potential opportunities you see before another investor takes them away:

• In a rapidly changing real estate market, conducting a reverse 1031 lets you lock in the right replacement property at the right price and the right time
• Buying the replacement property first provides you with more time to choose and negotiate the best deal to match your investment strategy
• Listing the relinquished property for sale after closing on your replacement property gives you more control over the price, and contract terms and conditions to stay within the 180-day timeline for successfully completing your reverse 1031 tax-deferred exchange

How to Conduct a Reverse 1031 Exchange

There are eight steps to follow when doing a reverse 1031 tax-deferred exchange:

1. Identify the replacement property and have the funds available to purchase, using cash, conventional financing, or short-term private money.
2. Execute a written agreement with your Exchange Accommodation Titleholder (EAT) who will take title and possession of your replacement property and hold it until the sale of your relinquished property closes.
3. Close on the sale of your replacement property, with the EAT taking title and actual possession.
4. Within 45 days of closing on the purchase of your replacement property identify the property to be relinquished.
5. Execute a written sales contract with a buyer for your relinquished property, making sure that the EAT is named as the seller of the relinquished property, and not you or the LLC you are holding the property under.
6. Execute an agreement with a QI, assigning them the right to transfer title of the relinquished property to the buyer, with the buyer also obtaining the right to take title of the replacement property from the EAT.
7. Within 180 days of the purchase of the replacement property close the sale of the relinquished property, ensuring that these three items are done:

• Convey relinquished property to the buyer through a deed
• Sales proceeds from the relinquished property must be transferred directly to the QI
• QI acquires the replacement property from the EAT, using the sales proceeds from the relinquished property.
• QI ensures that the replacement property is transferred to you from the EAT, and that the reverse 1031 exchange is properly completed.

Structuring a Reverse 1031 Exchange

Depending on your specific needs, there are two ways you can structure a reverse 1031 exchange:

Exchange First Reverse 1031 Exchange

• Exchange Accommodation Titleholder takes title to the relinquished property before the replacement property is purchased.
• EAT purchases the relinquished property based on the estimated fair market value.
• Funds to purchase the relinquished property are provided by you with title transferred to the EAT.
• A Qualified Exchange Accommodation Agreement and lease are signed with the EAT, allowing you to retain control of the property.
• A replacement property is located and purchased, with the EAT taking title and possession.
• Within 180 days of the EAT taking title to the replacement property you must close on the sale of the relinquished property.
• Sales proceeds from the relinquished property are send to you as reimbursement for the funds you provided the EAT to purchase the relinquished property.

Note: If the relinquished property sells for more than the estimated fair market value the EAT purchased the property for, boot will be created and capital gains tax on the boot will be due.

Exchange Last Reverse 1031 Exchange

• EAT takes title and possession of the replacement property when the purchase closes.
• Funds the EAT uses to purchase the replacement property are provided by you, and any mortgage on the replacement property must be structured in such a way that the EAT is named as the borrower.
• QI acts as the seller of the relinquished property, transfers title to the buyer of the relinquished property, and uses the sales proceeds from the relinquished property to purchase the replacement property from the EAT.
• This must occur within 180 days of the purchase of the replacement property by the EAT.
• EAT transfers the title of the replacement property to you, the QI transfers sales proceeds from the relinquished property to the EAT to complete the purchase of the replacement property, and the EAT uses those funds to pay off any existing loan used to purchase the replacement property.

Reverse 1031 Exchange Timelines

The timelines for a reverse 1031 tax-deferred exchange are the same as those for the other types of 1031 exchanges allowed by the IRS:

• 45 days: Relinquished property must be identified within 45 days of the closing of the purchase of the replacement property.
• 180 days: Relinquished property must be sold with closing taking place within 180 days of the closing of the purchase of the replacement property.

Takeaways

Conducting a reverse 1031 exchange can be more complex and expensive than a traditional delayed exchange, because there are more steps and people involved. 

However, if you have large amounts of equity in existing properties and believe the time is right to diversify your real estate portfolio, a reverse exchange may well be worth a little extra time and effort:

• A reverse 1031 exchange is the opposite of a delayed 1031 exchange.
• Replacement property is purchased first before the relinquished property is sold.
• Exchange First reverse exchange and Exchange Last reverse exchange are the two types of reverse 1031 tax-deferred exchanges.
• Reverse exchanges follow the same timelines as delayed and build-to-suit exchanges.
• Main benefits of a reverse 1031 exchange include maintaining more control over the entire exchange process and seizing the great investment deals that are appearing in many real estate markets today.