1031 Exchange Secrets
How to Defer Taxes & Build Passive Income in Real Estate
In This Article
- What is a Reverse 1031 Exchange?
- Reverse 1031 Exchange vs 1031 Exchange: What’s the Difference?
- Reverse 1031 Exchange Example
- Reverse 1031 Exchange Rules
- Reverse 1031 Exchange Timeline
- When To Do a Reverse 1031 Exchange…and When NOT To
- Reverse 1031 Exchange Frequently Asked Questions (FAQs)
- The Bottom Line: Reverse 1031 Exchange
There are several tools and strategies available for real estate investors today — if you know about them. If you are looking to buy a new investment property and then sell your current investment property, a reverse 1031 exchange can help.
But what is a reverse 1031 exchange? How does it work, and what is the reverse 1031 exchange timeline?
In this article, we’ll break down:
- what a reverse 1031 exchange is
- reverse 1031 exchange timeline
- reverse 1031 exchange rules
- how a reverse 1031 exchange differs from a regular 1031 exchange
If you're ready to learn everything you need to know about a reverse 1031 exchange, let's get started!
What is a Reverse 1031 Exchange?
The Reverse 1031 Exchange allows investment property owners to defer their federal capital gains taxes on the profits when they sell — if they use the profit to purchase another property.
The Reverse 1031 Exchange allows the owner to acquire the new property first, and then relinquish the property they own.
Reverse 1031 Exchange vs 1031 Exchange: What’s the Difference?
The 1031 Exchange is used by real estate investors to defer capital gains when they sell their investment property. In a regular 1031 Exchange, you sell your existing property first and then buy “like-kind” property.
In a Reverse 1031 Exchange, you buy the replacement property first, and then sell the existing property.
Reverse 1031 Exchange Advantages
The Reverse 1031 Exchange gives investors an advantage in competitive markets because they can purchase a property quickly — they do not have to relinquish the property they own first.
It is also useful when the current property has issues that affect a fast sale.
Reverse 1031 Exchange Disadvantages
The Reverse 1031 Exchange is more complicated than the typical 1031 Exchange, and it is more expensive.
Fees start at $3,500 and increase according to the size and complexity of the transaction, compared to $1,000 for a regular 1031 Exchange — a significant disadvantage.
In a Reverse 1031 Exchange, you fund the purchase of the new property without the proceeds of the sale of the initial property. If you use the Reverse 1031 Exchange and fail to sell your first property within 180 days, you will be responsible for the taxes.
Reverse 1031 Exchange Example
Let’s take a look at a Reverse 1031 exchange example to help explain it.
Meet Sam. Sam buys a property worth $750,000 and sells two properties worth $300,000 and $450,000. He buys the new property first and sells the original properties within 180 days. Sam cannot use the proceeds of the sale to buy the new property, so he finances the purchase by putting down 20% or $150,000,
Sam pays a Reverse 1031 Exchange fee of $4,000, a property fee of $300, plus a transfer tax to transfer the title of the new property to and from his Exchange Accommodation Titleholder (EAT).
The state rate is 1%, so he pays $7,500 both times for a total of $15,000. Sam has trouble selling his original property and incurs a $300 for a “rush fee” to meet the 180-day deadline.
Reverse 1031 Exchange Rules
With a Reverse 1031 Exchange, you have 45 days to name the property you intend to sell and 180 days to complete the sale. The replacement and existing properties must be “like-kind.”
You must use an Exchange Accommodation Titleholder (EAT) as well as a Qualified Intermediary (QI) to complete the exchange. The EAT is a “safe harbor” — think of it similar to escrow — established by the QI that holds the property being bought until you sell the original property.
Here are the basic Reverse 1031 Exchange rules:
- The seller and the buyer must be the identical taxpayer
- You must complete the Reverse 1031 Exchange within 180 days of closing on your replacement property
- You pay tax on the difference if the new property you buy is valued lower than the property you relinquished
- Neither property can be your primary residence
Reverse 1031 Exchange Timeline
Let’s take a look at a Reverse 1031 exchange timeline.
You are required to complete both the purchase and the sale of the properties within the timeframe designated by the IRS.
- You buy a replacement property.
- You have 45 days to identify which property or properties you will give up.
- You have another 135 days to sell your investment property.
- The transaction must be completed in 180 days from the purchase of the replacement property.
When To Do a Reverse 1031 Exchange…and When NOT To
A Reverse 1031 Exchange is a good idea if you have an opportunity to buy an investment property and you have to act fast. You can then consider which property to sell, and you will have time for negotiations.
A Reverse 1031 Exchange is more expensive and more complicated than a regular 1031 Exchange.
In a regular 1031 Exchange you use the proceeds from your initial sale for the purchase, but with a Reverse 1031 Exchange, you cannot.
If you don’t sell your existing property in 180 days, you will be responsible for taxes.
Reverse 1031 Exchange Frequently Asked Questions (FAQs)
Q. What is like-kind property in a 1031 Exchange?
Like-kind properties are similar in nature and must be for business or investment purposes, not a personal residence. The property must be held in the United States.
Q. What is the Exchange Accommodation Titleholder (EAT)?
The EAT is an LLC that buys the property you are relinquishing at the fair market value and uses the money from the sale to purchase your replacement property.
Q. What is a Qualified Intermediary?
The QI (Qualified Intermediary) is a liaison between the buyer, the seller and the IRS.
The Bottom Line: Reverse 1031 Exchange
Using the Reverse 1031 Exchange is a good idea if you are in a competitive real estate market. You may have the opportunity to buy another investment property at a good price, but you have to act fast — faster than the regular 1031 Exchange would allow.
With the Reverse 1031 Exchange you defer capital gains taxes like a regular 1031 Exchange, but the IRS permits you buy the property first and then sell the existing property for the exchange.
Keep in mind that there are more costs involved with the Reverse 1031 Exchange compared to a regular 1031 Exchange. It can get complicated since you are not allowed to hold the title to the property you are selling during the process.
But, in the right situation, it can be the best opportunity for you.