Reverse 1031 Exchange
What is a Reverse 1031 Exchange?
A reverse 1031 exchange is a type of property exchange as well as a tax strategy used to defer capital gains taxes when an investor sells his or her commercial property. A reverse 1031 exchange improves the position of the investment, enabling investors to take advantage of shifts in the market. Unlike a traditional 1031 exchange, a reverse 1031 exchange allows property owners to acquire the new replacement property prior to selling the property that is being replaced. Reverse exchanges exist to accommodate buyers who have found a new property they intend to purchase actually acquire that property before trading or selling the existing property they own. This permits the seller to continue owning the property until its market value increases. In turn, investors are awarded more time to sell to maximize their profits. Typically the maximum holding period accounts for about 180 days.
Why undergo a 1031 Exchange?
There are a variety of reasons that prompt investors to engage in a reverse 1031 exchange. Investors sometimes find themselves in the position where it is in their favor to acquire a similar property before selling the property they currently own. Investors sometimes come across a time sensitive investment opportunity that they must act on before they have the opportunity to sell or list their property. Sometimes the sale of the property that is within a 1031 exchange unexpectantly falls through. At that point, investors are at risk of losing the property that is being bought as the replacement because they may no longer receive the capital necessary to purchase a new property. Reverse 1031 exchanges protect investors from this potential risk. In some cases, investors want to eliminate the pressure of having to find a similar property that qualifies to go through a 1031 transaction within the 45 day identification period.
Whatever the circumstances may be that are pushing investors toward a reverse 1031 exchange, the transaction allows investors to acquire the replacement property first and then list and sell your relinquished property.
The Two Structures of a Reverse Exchange
Investors have the option to undergo a reverse exchange transaction one of two ways, the first being an exchange first approach, and the second being an exchange last approach.
Exchange Last Approach
When employing an exchange last 1031 exchange, the Exchange Accommodation Titleholder (EAT) temporarily acquires the down payment from the Exchangor (the investor who is undergoing the exchange) and the title of the replacement property. The EAT maintains sole ownership of the replacement property until a buyer is secured for the old property that is being sold and replaced. Once the sale of the old property is finalized, the returns from the sale go to the EAT which are then used to pay back the original loan between the Exchangor and the EAT. Then, the final step involves transferring ownership of the replacement property from the EAT to the Exchangor.
Exchange First Approach
In this approach, an EAT is created to retain the title of the old property that is being sold and replaced. The transaction begins with lenders directly lending to the investor to obtain the replacement property. As the investor purchases the replacement property, the title of the old property that is being replaced is simultaneously transferred to the EAT. The EAT maintains ownership of the old property until a buyer is found. Once the old property is sold, the title will be transferred from the EAT to the buyer. The final stage of the process involves pay off the initial loan that was between the Exchangor and the EAT using the returns of the sale of the old property.
Reverse 1031 Exchange Qualifications and Requirments
It is necessary for Exchangors to have the financial means to purchase a replacement property without having the proceeds from the sale of their original property to be considered for a reverse 1031 exchange. The EAT does, however, acquire a loan to pay off the down payment of the new property. This loan is generally repaid once the Exchangor’s old property is sold. The requirements of a reverse exchange include:
- The investor that is selling the property must be the same investor that is buying the replacement property.
- The new property that is being purchased must be of equal or greater value than the property that is being replaced.
- If this is not the case a tax is triggered on the difference of price
- Neither of the properties in the transaction can be the primary residence of the Exchangor.
- The entire reverse exchange process must be completed within 180 days of the initial closing.