Summary: In this article, learn about the reverse 1031 exchange process and timeline. Topics also include benefits of a reverse exchange, two common types, rules and regulations, the costs and risks involved, and steps for doing a reverse exchange.
If you’ve been researching 1031 exchanges online, you’ve probably come across our popular article: How To Do a 1031 Exchange: Rules & Definitions for Investors. In that article, we give a high level 1031 overview, which includes a brief breakdown of the different types of exchanges available to investors. If you haven’t checked it out yet, I’d suggest starting there.
In this article, we’re going to provide a deep dive into one of the most common exchange types: the reverse 1031 exchange. We’ll explain how the reverse exchange works and how real estate investors use this unique strategy for more than just the tax advantages.
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What is a Reverse 1031 Exchange?
A 1031 exchange is a common strategy that real estate investors use to defer paying taxes when selling a property. The idea is that an investment property is exchanged or swapped for a second, like-kind property. This allows investors to postpone paying capital gains taxes and other taxes associated with selling the property.
A reverse 1031 exchange is just that–the process of a 1031 exchange, but reversed. With a reverse exchange, an investor can buy a replacement property first, and then sell their existing property after that.
It sounds straightforward, but there are certain guidelines investors must follow, outlined by the IRS. It isn’t as easy as simply replacing one of your existing investment properties with another one. For instance, investors cannot hold the title of the property they’re planning to sell during the reverse 1031 exchange process.
However, executing a successful reverse exchange is completely doable and comes with a lot of benefits to investors.
Benefits of a Reverse 1031 Exchange
There are a number of benefits to using a reverse exchange. These include:
- You can buy a replacement property in a competitive market when you want and at the price you want.
- If you are paying for the property in cash, you don’t have to worry about finding a replacement within the 45-day timeframe, like with an ordinary 1031 exchange.
- Time to consider which property or properties to sell/exchange for your replacement property investment.
- It also gives you time to negotiate a selling price, contract terms, conditions, etc. with the buyer of the relinquished property.
- Like a typical 1031, it allows you to avoid paying capital gains taxes and other taxes–at least for now.
Next, we’ll break down the roles of key players in the reverse exchange process…
QEAA or Qualified Exchange Accommodation Arrangement
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.).
EAT or Exchange Accommodation Titleholder
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.
QI or Qualified Intermediary
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.
Reverse 1031 Exchange Timeline
The investor must complete the purchase and sale of both properties within the designated time frame set by the IRS. From the date the new property is bought, the investor has:
- 45 days to identify which property or properties to give up.
- After that, you have another 135 days to sell your investment property.
- The full transaction must be completed within 180 days of the purchase date of the replacement property.
During the 180 time period, the property is held and protected under the IRS’ Revenue Procedure safeguard.
Reverse 1031 Exchange Rules
The most common type of exchange today, a delayed exchange, is when the investor sells a rental property and then purchases a replacement property. The rules of a reverse exchange are the same as a delayed 1031 exchange, with a few variances:
- The buyer and seller must be the same taxpayer.
- The reverse exchange must be completed within 180 days of closing on a replacement property.
- If the new property is worth less than the relinquished one, taxes will be imposed on the difference.
- Both the replacement and relinquished properties CANNOT be primary residences of the taxpayer.
If these reverse exchange rules and requirements are not met, investors will likely end up paying a lot more in capital gains taxes than they wanted to–at least right now.
Types of Reverse 1031 Exchanges
Reverse exchanges can be done in a couple of different ways: the exchange last and the exchange first.
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.
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.
How to Do a Reverse 1031 Exchange: Step-By-Step Guide
Because the reverse exchange process is a bit trickier, it’s always smart to consult with your financial advisor, the EAT and a Qualified Intermediary that will manage the exchange. Here are eight steps to the reverse exchange process:
Step 1: Find a replacement property and decide how you will fund the purchase. Investors may choose to buy in cash or go through a lender. Both the lender and title company need to be made aware that you are performing a reverse 1031 exchange. Remember, the new property must be at least as valuable as the property you plan to exchange.
Step 2: Reach a QEAA with your EAT. The agreement should outline the terms and conditions of holding the title during the exchange process and transfer upon closing of the old property.
Step 3: The EAT takes over the title after financing and holds it for you until the exchange is complete.
Step 4: Decide which property/properties to sell. Once the EAT has the title of your new property, you have 45 days to decide which properties (allowed up to three) will be sold.
Step 5: Find a buyer for your property within 135 days and go under contract.
Step 6: Make an agreement with your Qualified Intermediary who is responsible for handing over the title to the buyer and acquiring the title to your new property.
Step 7: Transfer the deed of the relinquished property to the buyer. At that time, the buyer will transfer funds to the QI and essentially buy your parked property from the EAT.
Step 8: Obtain the deed to your new investment property. Once all the money has gone through, the EAT will then transfer you the deed to your replacement property.
And that’s it! You’ve just completed a reverse 1031 exchange.
Costs & Risks of a Reverse 1031 Exchange
There are typically more costs associated with a reverse exchange, which naturally increases risk because stakes are higher. A big reason for the extra costs is because it’s impossible to do the process yourself. The cost of a reverse exchange is around $3,500.
A QI will often charge a larger fee to manage a reverse exchange because it’s a more complex process. When your new property is transferred to an EAT, the IRS will be notified and apply transaction costs. Investors should expect costs like transfer fees, mortgage taxes, lender, escrow and title fees, etc.
Along with extra costs, there are a number of risks associated with a reverse exchange.
- If you can’t sell your property within the set timeframe.
- If your loan doesn’t get approved for the new property.
- If you don’t have enough cash on hand to buy a replacement property prior to selling your relinquished property.
- If you don’t have enough time to make the necessary improvements on the property you wish to sell.
While the reverse 1031 exchange process is more complicated than other types of exchanges, investors are successfully doing them all the time. Just like you would with any major investment decision, make sure you have a plan in place before jumping in. Utilize expert resources to assist you throughout the exchange process and keep doing your part to increase your knowledge of the process and understand expectations.