Reverse 1031 Exchange Guide: What It Is & How to Do It

In order to understand what a reverse 1031 exchange is, it’s helpful to know what a regular 1031 exchange is.

In a nutshell, a 1031 exchange is a strategy used by real estate investors to postpone paying taxes on their capital gains if they are using the sale of one property to purchase a like-kind property.

And a reverse exchange is, as the name implies, a 1031 exchange in reverse. You acquire the property you’re purchasing before you sell the property you’re using in the exchange.

It’s not as simple as it sounds, however. There are rules you have to follow and you’ll have to put up a fair bit of money and time to successfully do a reverse exchange. But for the right property, you could end up saving a lot in taxes. Let’s dive into the Reverse 1031 Exchange, and whether it might be worth it for you.

The Short Version

A 1031 Exchange is when one property is sold before the replacement property is purchased.
A Reverse 1031 Exchange is used by real estate investors who want to purchase the replacement property before selling the relinquished property.
You must use a third party EAT (Exchange Accommodation Titleholder) to handle the transaction.
Similar to 1031 Exchanges, the 45-day and 180-day deadlines apply to Reverse exchanges.
If your 1031 Reverse Exchange fails, you may owe taxes and penalties to the IRS.

How Does a Reverse 1031 Exchange Work?

For the purposes of 1031 exchanges, it’s prohibited to own both a property that you’re selling and a property you want to buy to replace it at the same time.

However, what you can do is acquire and hold your replacement property in a separate special purpose entity before you sell your original one. This takes the title to the property under a “Qualified Exchange Accommodation Arrangement (QEAA).” That’s a reverse 1031 exchange.

To successfully qualify for and complete a reverse 1031 exchange, there are specific rules and timelines to follow. One big one is that you cannot represent yourself in the transaction – you need to use an independent third party. If you’re doing a regular 1031 Exchange, you use a Qualified Intermediary (QI). If you’re doing a reverse exchange, the transaction is initiated and completed using an Exchange Accommodation Titleholder (EAT) through the QUAA document mentioned above.

Reverse 1031 Exchange Timeline

The process works like this:

The property you’re trying to buy is transferred to the EAT, which is typically an LLC entity. That ensures that you, the taxpayer, do not personally own the property.
Within 5 days of this transfer, there must be a written and executed QEAA.
Within 45 days of transferring the property to the EAT, you must identify and record the property you’re selling in the 1031 Reverse Exchange.
The combined total timeframe that both properties are held in the QEAA by the EAT can be no longer than 180 days.

Related >>> How to Buy an Investment Property

What Types of Properties Qualify for a Reverse Exchange?

Similar to a standard 1031 Exchange, a reverse exchange can only be done when exchanging one property with another “like-kind” property. According to the IRS, properties are considered like-kind if they are “of the same nature or character, even if they differ in grade or quality.”

That means that a commercial property is like-kind to another commercial property even if they are customized to fit different types of businesses. And the IRS says that an apartment building would be like-kind to another apartment building even if one is newly built and the other is outdated and in serious need of rehab before it’s move-in ready.

Like-kind properties can be located in different states, for example California and Florida. However, two properties are not like-kind if one or both are located outside of the U.S.

What To Be Aware Of When Filing a Reverse 1031 Exchange

There are several reasons why a 1031 reverse exchange may fail. Here are a few considerations to be aware of.

Missing the deadlines and/or not complying with all the IRS rules will render your transaction ineligible for tax deferment.
Taking cash or other proceeds before the exchange is complete may disqualify the transaction and make all gain immediately taxable.
As mentioned earlier, acting as your own EAT or QI is prohibited. In addition, your agent, attorney, broker, accountant, employee or anyone who has worked for you in the past two years cannot act as your QI or EAT.

Important Tip: Be sure to do your due diligence on the third-party QI or EAT you choose. Unlike financial institutions that are FDIC-insured, qualified Intermediaries are unregulated. There have been cases of bankruptcy resulting in losses of some or all of the funds held for investors in the process of a 1031 exchange.

If you cannot successfully complete your exchange, the taxes you were attempting to defer are due to the IRS immediately.

Capital Gains Taxes are Deferred, Not Forgiven

When you do a 1031 exchange, the taxes on your capital gains are deferred, not cancelled. You need to eventually pay the tax when you sell the acquired property (unless you do another 1031 when you sell that property and defer the tax again).

Record keeping is important as you’ll need to correctly adjust and track your basis (as in, the cost of the property plus expenses incurred in the sale) correctly to comply with the 1031 Exchange. The basis of the property acquired is the basis of the property relinquished with some adjustments.

The result is that the depreciable basis is generally lower than it would have been if acquired in a taxable transaction. You must keep track of your basis for the acquired property and carry it forward.

When Should You Consider a Reverse 1031 Exchange?

Successfully completing a 1031 standard or reverse exchange requires time and money. So, is it worth it?

Depending on how much you stand to gain, the scale of the property and how much your Exchange Accommodation Titleholder would charge you, it might certainly be worth the trouble.

Let’s say you’re currently invested in a small 6-unit multifamily and you’ve been watching for an opportunity to acquire a larger property. A 65-unit apartment complex comes on the market and you don’t want to miss out on purchasing it.

The current market value of your 6-unit has increased since you’ve owned it and your projected profit if you sell is $200,000. Without a reverse exchange, the capital gains taxes at 20% would eat $40,000 of your profits. Meanwhile, doing a reverse exchange would defer all of those capital gains taxes. In this instance, the reverse exchange is the best way forward.

If, on the other hand, the taxable gains you’re likely to yield from the property you’re selling and the property aren’t very high, you may choose not to put in the time and money to hire an Exchange Accommodation Titleholder (EAT) and go through the hassle of a reverse 1031 exchange.

Learn more >>> Investing In Apartment Buildings: How To Get Started

When Should You Not Consider a Reverse Exchange?

If you can follow all the rules and it makes sense for your investing strategy, a 1031 exchange or reverse exchange can be an excellent tool. By deferring capital gains, you keep more of your money actively invested in income-generating real estate.

However, a reverse 1031 exchange is NOT the right strategy in many cases. Here are a few reasons why it might not be worth it for you:

You don’t stand to gain much at the end of the day. The fees for a third party representative tend to be around $1,500 which eats into your profits. On transaction where you might only be deferring a few thousand dollars in taxes, this can be a significant hit.
You want to invest in something other than real estate. A reverse 1031 exchange only applies to investing in like-kind investment properties.
You need the money immediately. During the 6-month 1031 exchange process, your funds are held in escrow by the QI or EAT. That means you won’t have access to the funds.
The 45-day window to identify a relinquished property is too short for you. Housing markets are constantly changing. If you don’t think you’ll be able to hone in on one of your properties that you’d be able to relinquish in 45 days, you may not want to start a reverse exchange.
The 180-day deadline to sell the relinquished property is too short for you. Buying a property isn’t like buying a consumer good. Delivery isn’t immediate after you choose what you want to purchase. Settlement delays happen often which can put the deadline for your exchange out of reach.

The Takeaway: Is a Reverse 1031 Exchange Right For You?

For the right situation, the reverse exchange can be a great strategy. It can keep more of your money invested rather than forking over your gains to Uncle Sam and losing it forever. Like any other investing strategy, make sure to crunch the numbers to see if it’ll work out for you before you start the process.

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