What is a Reverse 1031 Exchange?
You’ve heard of the 1031 exchange (if not, now would be a great time to check out our blog post on this!). But what are reverse 1031 exchanges and how do they work?
To recap, 1031 Exchanges allow investors to swap an investment or business property for like-kind property of equal or greater value while deferring capital gains taxes. If your property meets the requirements, you can exchange it for another investment or property and have limited or no tax due at the time of the swap.
What Exactly is a Reverse Exchange?
A reverse exchange is a type of property exchange wherein the replacement property is acquired first, and then the current property is traded away. A reverse exchange was created to help buyers purchase a new property before being forced to trade in or sell a current property. This may allow the seller to hold a current property until its market value increases, thereby also increasing their own timing to sell for maximized profit.
The Reverse Exchange is the opposite of the Delayed Exchange. Where the Delayed Exchange requires the Exchangor to relinquish property before he acquires property, the Reverse Exchange allows the Exchangor to acquire property first and relinquish property second. In other words, the Reverse Exchange allows an investor to acquire a new property today, when an excellent investment may be available, and sell other property later when a better price might be obtained.
The Reverse Exchange greatly expands the ability of the investor to take advantage of changes in the marketplace and to improve his or her investment position.
Standard like-kind exchange rules usually do not apply to reverse exchanges. Such rules typically allow a property investor to discontinue payment of capital gains taxes on a property they have sold so long as the profit from that sale is applied toward the purchase of a “like-kind” property. The IRS has created a set of safe-harbor rules that allow for like-kind treatment, as long as either the current or new property is held in a qualified exchange accommodation arrangement, or QEAA. Additionally, the investor cannot use property already owned as a replacement for the relinquished property.
Reverse exchanges apply only to Section 1031 property, so it is also referred to as a 1031 exchange. Section 1031 properties are properties that businesses or those with qualifying organizations exchange in order and defer paying taxes on any profit gained from their sale. However, it’s not as simple as an individual taxpayer buying one property, selling it, then using the profits to buy another property. Instead, there must be a set standard of exchange as well as the presence of a facilitator who is used to set up the process. Section 1245 or 1250 properties are ineligible for this type of transaction.
Reverse 1031 Exchange Requirements
Generally, there is a maximum holding period that applies to properties in reverse exchanges, typically averaging around 180 days. The opposite of a reverse exchange is the delayed or deferred exchange, in which an exchanger must first relinquish owned property by trading or selling before acquiring a new property.
Reverse exchanges are often used in cases where a property investor must close on the sale of a new property before being able to sell their current property. Cases such as these include the unexpected discovery of a desirable new property that must be purchased within a short amount of time or situations in which the sale of a currently-held property falls through unexpectedly, thus leaving a reverse exchange as a potential fix that allows the investor to continue the purchase of a new property.
Reverse 1031 Exchange Terms to Know
Qualified Exchange Accommodation Arrangement (QEAA)
A qualified exchange accommodation arrangement or QEAA is the exchange agreement between you, the taxpayer, and the EAT. The QEAA is meant to be a safeguard to hold properties during an exchange as a shelter from taxes.
Under the IRS’ Revenue Procedure 2000-37, if an investor meets the requirements of a QEAA, they won’t be taxed upon exchange of the properties. There’s been some grey area regarding which assets qualify under this revenue procedure. Near the end of 2019, the IRS finally clarified that rental real estate qualified for these safe harbor benefits.
Before executing a QEAA, it’s wise to already know which property you’re going to buy and how it will be funded (cash, financing, etc.).
Exchange Accommodation Titleholder (EAT)
The taxpayer and EAT must both agree to and follow the QEAA. Because investors are not allowed to hold the title of the property they’re relinquishing for the duration of the exchange, the EAT acts as a holding cell.
Think of the EAT as an LLC. Essentially, the EAT buys the property you’re getting rid of, at fair market value, and becomes the titleholder for tax purposes. When your rental property sells, the money from the sale is used to purchase your replacement property.
Once you’ve purchased a replacement investment property and have a buyer under contract for your property–next you will need a Qualified Intermediary.
Qualified Intermediary (QI)
The Qualified Intermediary acts as sort of a liaison between buyers, sellers and the IRS. The money from the sale of the property you turned over is transferred to the QI and used to “buy” the title from the EAT. The main responsibility of a QI is to transfer the titles of both properties from the EAT to their respective owners, which then completes the exchange.
The QI ensures that the reverse 1031 exchange process was done correctly and qualifies the investor for tax advantages.
Types of Reverse 1031 Exchanges
Exchange Last
The most common type of reverse exchange is an exchange last reverse. During an exchange last reverse, the EAT holds the title of the “replacement” or new property until your “relinquished” property is sold.
The exchange last reverse gives investors more flexibility. On the other hand, it can present issues when working with certain lenders because their reverse 1031 exchange policies tend to vary. Call around to find out which lenders will work with the EAT keeping the property title during the exchange process.
Exchange First
For an exchange first reverse, investors buy a new investment property directly through a lender and simultaneously turn the title over to the EAT. However, most lenders require you to reinvest all the equity from the property you sold into the replacement property.
The problem is, money must be put toward the new investment property in order for the sale to become final. This means an investor will have to have a lot of cash-on-hand.
Ready to Explore Your Options?
As your qualified intermediary, Growth 1031 is experienced and fully equipped to facilitate your reverse 1031 exchanges. We walk you through all stages of the exchange and guide you through every step. Per California law, our Exchange Accommodators are also licensed and bonded for your peace of mind. Whether you want to learn more about 1031 exchanges or are ready to get into the exchange process, we’d love to hear from you! Contact Growth 1031 for a consultation today.
Disclaimer: Growth 1031, Inc. is a qualified intermediary that specializes in facilitating 1031 exchanges. Growth 1031, Inc.is not a law-firm and does not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.