What is a Reverse 1031 Exchange?
The 1031 Exchange allows a person to sell one or more appreciated assets (generally rental or investment real estate) and defer the payment of capital gain taxes by acquiring one or more replacement properties. 1031 Tax Deferred Exchanges allow you to keep 100% of your money working for you instead of paying about one-third of your equity to Uncle Sam.
There are 4 common options in performing a 1031 Exchange. The most common like-kind exchange types include the simultaneous, delayed, reverse, and construction (or improvement) exchange. Depending on what order you acquire a replacement property and sell your relinquished property, you will fall under one of those options.
The most common type of exchange is the delayed exchange, where an investor sells the investment property first, THEN acquires a replacement.
A reverse 1031 exchange is exactly as it sounds: instead of selling an existing investment property and then buying a new one, the investor buys a new property and sells the relinquished one afterwards. Other than the order of operations, almost all the regular rules of a 1031 Exchange remain the same in a reverse 1031 Exchange.
What do you need to know?
The process of using a reverse 1031 Exchange sometimes seems more complicated than a regular exchange. For starters, in a reverse exchange, you cannot hold the title of the property you buy right away. The title of your future property has to be held by an Exchange Accommodation Titleholder who will acquire and hold the target property in a separate special-purpose entity, typically a single member LLC, pending completion of the exchange process.
One other thing the investor has to keep in mind is timing. The deadlines to complete a reverse 1031 exchange also function in reverse. The 45-day identification window in a regular exchange is still in effect, but the purpose of this deadline is to identify the property you are going to SELL. Similarly, you will have to complete selling your property within 180 calendar days starting from the closing of the property you bought. This should be the easy part in a seller’s market!
Advantages of a Reverse 1031 Exchange
Many real estate investors choose a reverse 1031 exchange to ensure they have a replacement property, thus reducing their risk of paying capital gains taxes. A reverse 1031 exchange is most beneficial in a seller’s market where demand for properties outweighs supply. By purchasing your replacement property first, you are essentially getting the hard part over with, making the rest of the process smooth sailing and guaranteeing a successful transfer.
Considerations Before You Start
In most normal real estate transactions, homeowners need to sell their primary residence first in order to have the funds available to purchase their next home. The same goes with investment properties. If you do not have liquid assets on hand to purchase the replacement property before you sell, you will need to get a loan. This can be hit-or-miss with properties that are held by an Exchange Accommodation Titleholder, so it’s best to inquire with your lender before you begin the process.
If you are considering a 1031 exchange, don’t go at it alone! We’d be more than happy to answer any of your questions and help get the process rolling in the right direction.