Reverse 1031 Exchange: Process, Benefits and Potential Risks for Investors
What is a Reverse 1031 Exchange?
A reverse 1031 exchange, also known as Revenue Procedure 2000-37, was established by the Internal Revenue Service on September 15, 2000, to provide safe harbor for investors who want to acquire a replacement property before selling a relinquished property. This tax-deferral strategy enables investors to move quickly to take advantage of real estate opportunities and also provides more flexibility to locate a like-kind property. Unlike a forward 1031 exchange, a reverse 1031 exchange allows an investor to own their replacement property before selling the relinquished property as long as the property agreement meets certain requirements for federal tax purposes.
Similar to a forward 1031 exchange, it’s important to note that a reverse 1031 exchange pertains to investment properties only. You can learn more about what properties qualify for a 1031 exchange here.
If you are considering pursuing a reverse 1031 exchange agreement, it is worthwhile to seek knowledgeable legal and financial counsel as the contracts involved can be complex.
The Rules of a Reverse 1031 Exchange
Although somewhat similar to the rules and requirements for a 1031 exchange, a reverse 1031 exchange can be a bit more complicated (and costly). Under the safe-harbor rules established by the IRS, the replacement property has to be purchased before the relinquished property can be sold. For this to be possible, a Qualified Intermediary (QI) must be involved. The QI acts as the facilitator and manages the exchange of funds between both parties. To do so, a Qualified Exchange Accommodation Agreement (QEAA) is created. This agreement will allow an Exchange Accommodator Titleholder (EAT) to become the titleholder for either the relinquished property or the like-kind replacement property during the reverse 1031 transaction process.
After the replacement property has been purchased, the investor must decide which investment property (or properties) will be held or “parked” by the EAT. Once the agreement has been signed, the EAT will hold the title for the property that has been “parked” by the investor but the investor will still be responsible for the property expenses and income produced. The EAT is only considered the owner of the property for federal tax purposes since the investor cannot own the relinquished property and the replacement property simultaneously.
Once the EAT has ownership of either the relinquished property or the like-kind replacement property, the investor has 45 days from the point of purchase to designate up to three properties to sell, thereby beginning the traditional (aka forward) 1031 exchange model. The two most common structures here are Exchange First and Exchange Last, which are explained in further detail here. It is a good rule of thumb for the investor to know what properties they would like to sell before beginning the reverse 1031 exchange process.
After the investor has listed the property they wish to sell, they will have an additional 135 days to get the property under contract and close. This gives the investor a total of 180 calendar days to complete the reverse 1031 exchange process.
Within this 180 day period, the investor will also have to buy back the property from the EAT. This is where a competent financial advisor can really come in handy since the investor will need to be sure to satisfy the taxpayer requirements established in the QEAA.
This 180 day timeline is non-negotiable. If an investor cannot complete the entire process within the designated timeframe, the reverse 1031 exchange becomes invalid and the investor will need to pay taxes on both properties since the EAT is not liable.
The Benefits of a Reverse 1031 Exchange
- An investor will have the flexibility to purchase an investment property quickly before others are able to do so, even if the investor hasn’t had time to consider selling their relinquished property.
- The reverse 1031 exchange gives an investor more flexibility to hold onto their real estate and wait for a better offer since they can legally acquire property before relinquishing anything.
- An investor has the ability to reduce the risk involved in the exchange since they are able to acquire the like-kind property first and then have 45 days to identify which relinquished property or properties they wish to sell.
- If the relinquished property doesn’t sell or close within the 180 day deadline, the investor will not have any income tax consequences since the relinquished property has not sold. The reverse 1031 exchange will be void, however, and the investor will end up owning both properties.
- The structure of the reverse 1031 exchange gives investors the potential to invest more capital in the replacement property since they can defer the capital gains taxes.
The Risks of a Reverse 1031 Exchange
- There is the possibility that construction could be needed prior to closing and the improvements cannot be made within the 180 day timeframe.
- The investor is unable to sell the relinquished property.
- A lender could be unwilling to approve a loan since property will be held by an EAT.
For additional information, please refer back to our full list of Real Estate FAQs.