Reverse 1031 Exchange Definition
REtipster does not provide tax, investment, or financial advice. Always seek the help of a licensed financial professional before taking action.
How Does a Reverse 1031 Exchange Work?
In a standard 1031 exchange (also called forward or delayed exchange), the taxpayer sells the property they wish to exchange and turns the proceeds over to a qualified intermediary. To reap the tax benefits from this process, they must identify and complete the purchase of the replacement property in 45 and 180 days, respectively.
The problem with a standard 1031 exchange is that the taxpayer must wait for the relinquished property to sell before buying a replacement property. Depending on the local real estate market, the relinquished property could be listed for months or even years before reaching a sales agreement. That means the taxpayer could miss out on purchasing a suitable replacement property at an attractive price.
The reverse 1031 exchange can address that problem. Under a reverse 1031 exchange, the taxpayer buys the replacement property first, then sells the relinquished property.
Tax Benefits of a Reverse 1031 Exchange
Profit in real estate investing often depends on a solid tax strategy to limit capital gains tax liability. Investors can use a reverse 1031 exchange to avoid paying taxes on the increase in the value of an income-producing property.
The term “1031 exchange” takes its name from Section 1031 of the Internal Revenue Code. Under Section 1031, a taxpayer can defer recognition of capital gains tax liability on the exchange of certain types of property. These properties include those that have been and will continue to be used for investment or in a trade or business.
Example of a Reverse 1031 Exchange
A reverse 1031 exchange works like this:
Ingrid Investor has a rental property near her home in Los Angeles. She has bought it for $300,000 but is now valued at $500,000. She is moving to Florida and wants to sell her LA rental and buy a rental property closer to her new home in Miami, but she does not want to pay capital gains on the $200,000 in appreciated value.
On a house-hunting trip, she discovers a duplex in Miami priced at $500,000, so she decides to do a 1031 exchange to defer capital gains tax.
It is a seller’s market in Miami; Ingrid needs to buy the duplex right away to not lose out on an ideal investment. She decides to use a reverse 1031 exchange to purchase the duplex (the “replacement” property) now and sell her LA rental (the “relinquished” property) later.
She executes a sales agreement for the duplex and parks the title with an Exchange Accommodator Titleholder (EAT).
On her return to LA, she finds a buyer for her rental house and hires a qualified intermediary to hold the proceeds and acquire the Miami duplex from the EAT.
The intermediary hands over the relinquished property deed to the LA buyer and the deed for the replacement duplex to Ingrid. Ingrid now has a rental property near her home in Miami and defers capital gains tax on the sale of her LA rental.
Reverse 1031 Exchange Restrictions
Most of the IRS rules regarding forward 1031 exchanges apply to a reverse 1031 exchange, too. For example:
- The taxpayer must observe the 45- and 180-day timelines. If the taxpayer has more than one potential exchange property, they must designate the relinquished property within 45 days of parking the replacement property with the EAT. They must then complete the sale of the relinquished property by the 180th day.
- The like-kind property requirement applies. All real estate in the U.S. is like-kind to other real estate, as long as it is used for business or investment purposes. For example, an investor could exchange a warehouse for an apartment building or a single-family rental for farmland. However, a taxpayer cannot exchange U.S. property for foreign real estate or income-producing property for a second residence.
- The market value of the replacement property must be equal to or greater than the relinquished property. When the value of the replacement property is less than the relinquished property, it is considered a partial exchange. Capital gains tax applies to the boot (the difference in value between the two properties).
- The mortgage on the replacement property must be at least as large as the mortgage on the relinquished property. If the loan on the replacement property is less than the loan on the relinquished property, the difference is treated as boot, subject to tax.
- The same taxpayer must appear on all documents. The name on the tax return must match the name on the title of the property being sold and the titleholder of the new property. There is an exception for single-member LLCs, which serve as a pass-through to the taxpayer.
- Related party and disqualified person restrictions apply. Family members, other related parties, and individuals who have acted as agents for the taxpayer within the previous two years cannot be a party to a 1031 exchange. The IRS defines agents as the taxpayer’s employee, accountant, attorney, broker, banker, or real estate agent.
Special Considerations for a Reverse 1031 Exchange
The taxpayer cannot hold the title for both the relinquished and replacement properties at the same time, which is why an EAT is required to hold one title for the duration of the exchange. However, the taxpayer can decide whether to park the title of the replacement or relinquished property.
If the taxpayer parks the relinquished property title with the EAT, they continue to pay all loan payments and operating expenses. They also receive any income generated by the property.
If the replacement property is parked with the EAT, the taxpayer must arrange financing for the new property. When the relinquished property sells, they are reimbursed for their acquisition costs. The exchange fails if the property does not sell by the 180th day. The title to the new property is then automatically conveyed to the taxpayer.
Several special considerations determine whether the taxpayer should park the relinquished or replacement property with the EAT:
- In an “exchange last” reverse 1031 exchange, the EAT takes the title of the replacement property at closing. It can be difficult for the taxpayer to find a lender who will structure the loan with the EAT as the borrower.
- Many states have a transfer tax on the conveyance of title. The state typically waives the tax if it recognizes that the EAT is the taxpayer’s agent. If it does not, however, these tax consequences need to be factored into the decision about which title will be parked.
- If the relinquished property has a mortgage, parking it with the EAT may trigger a “due on sale” clause. The taxpayer should contact the lender to learn how these transfers happen and if there is a grace period for a reverse 1031 exchange.
Potential Risks of a Reverse 1031 Exchange
A reverse 1031 exchange allows taxpayers to take advantage of market trends—they can buy a suitable property at a good price before selling the relinquished property. However, it also presents several risks.
- It may be difficult to get traditional financing, which means the taxpayer may need to have cash on hand or other sources of capital to acquire the property.
- If the market is slow for the relinquished property, it may not sell within the 180-day timeframe. This results in a failed exchange, which would void the tax advantages and result in the taxpayer owning both properties and potentially paying mortgages for both.
- If the replacement property needs improvements, it must be completed within the 180-day timeframe to take advantage of the tax deferral. Otherwise, only the completed portions will be applied to the deferral.
Understanding Reverse 1031 Exchange Costs
Taxpayers can expect to pay a lot more for a reverse 1031 exchange than a traditional forward exchange. The fees associated with the exchange vary considerably, though the state where the exchange takes place standardizes them. Fees also differ by the number of properties involved. For example, the average cost for a reverse 1031 exchange is between $3,500 and $7,500 in 2018.
The taxpayer must also pay other fees, such as financing fees, property taxes, insurance premiums, and repair and maintenance costs. However, they can elect to pay some expenses (commissions, qualified intermediary and attorney fees, filing fees, escrow fees, and the services of a tax advisor) with the proceeds from the exchange.
A 1031 exchange is a way to offset capital gains tax liability by exchanging one property for another of equal or greater value. In a standard 1031 exchange, the taxpayer first sells the exchange property and then buys the replacement property. A reverse 1031 flips the process so that the taxpayer first buys the replacement property and then sells the exchange property.
- Orem, T. (2020.) 2020 Capital Gains Tax Rates — and How to Calculate Your Bill. NerdWallet. Retrieved from https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates
- Internal Revenue Service. (n.d.) Like-Kind Exchanges – Real Estate Tax Tips. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/like-kind-exchanges-real-estate-tax-tips
- Gustafson, T. (2018.) How Much Does a 1031 Exchange Cost? Atlas 1031. Retrieved from https://atlas1031.com/blog/how-much-does-a-1031-exchange-cost/