Understanding 1031 Exchanges

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As soon as you realize that you may qualify for a 1031 exchange, contact a qualified intermediary (QI). Contact a QI before closing on your relinquished property. Doing this prevents you from missing the opportunity to enter an exchange. The QI will tell you if you qualify for an exchange and which type of exchange works best. There are several 1031 exchange options available to taxpayers, depending on their unique transactions. Here, we discuss the definition, rules, and situations that work best for each type of exchange.

Exchanges (whether standard or reverse/improvement) need advanced preparation. This preparation ensures adherence to regulatory requirements. This also gives all involved parties ample time to update their documentation.

Midland 1031 is available to discuss your transaction with you. We review the 1031 exchange process step by step.

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Types of 1031 Exchanges

Standard Exchanges

Delayed

Standard exchanges are the most common type of 1031 exchange. They involve the sale of a relinquished investment property and the purchase of a replacement investment property. This type of exchange must occur within 180 days from the sale of the relinquished property.

Simultaneous

Simultaneous Standard Exchanges can happen in two ways. The first way involves two parties who “swap” properties with each other. The second way is when the exchanger closes on the sale of the relinquished property and buys the replacement property on the same day.

Replacement Reverse

When performing standard 1031 exchange transactions, investment property sells first. After this sale, the seller buys a new piece of real estate. A reverse exchange allows you to buy the new property before selling the existing one.

IRS Revenue Procedure 2000-37 sanctions the reverse exchange “safe harbor” rule. This procedure provides a parking arrangement for investments. Suppose a seller cannot sell the existing property within the standard 1031 exchange time frame. In that case, an Exchange Accommodation Titleholder (EAT) can hold title on the desired property until the first property sells. The seller is then able to take possession of the new investment parcel from the EAT.

Reverse Exchange Rules

  • Reverse exchanges have a 180-day deadline. The 180-day countdown starts on the date the EAT buys the replacement property for the taxpayer/seller.
  • Within 45 days after the purchase of parked property, the taxpayer must formally identify the relinquished property(s).
  • The EAT and the taxpayer must complete a Qualified Exchange Accommodation Agreement.

When a Reverse Exchange Is Useful

  • The owner of the investment property finds the ideal replacement property before finding a buyer for the exchange property.
  • The real estate investor needs to buy prime real estate as it enters the market.
  • Real estate sellers wish to avoid identifying replacement property in the 45 days required by a 1031 exchange.

Forward Reverse Exchange

Often, a taxpayer considering a reverse exchange will not have the cash to fund purchasing the new replacement property. They often need financing for the purchase. Depending on the lender’s financing structure restrictions, it may not be possible to park the replacement property in the EAT. The taxpayer may be able to structure a "Forward" or "Relinquished Reverse Exchange." Here, the taxpayer parks the relinquished property with the EAT rather than the replacement property in the EAT. Using this approach, the taxpayer transfers their interest in the relinquished property. Doing this allows them to buy the replacement property in their name. Certain restrictions apply for completing this type of exchange.

Forward Reverse Exchange Rules

  • In a Forward Reverse Exchange, the EAT takes title to (or parks) the relinquished property. Doing this allows the taxpayer to directly acquire the replacement property. Exercise caution before deeding the property to the EAT if there is a loan on the relinquished property.
  • Forward Reverse exchanges have a 180-day deadline. The 180-day countdown starts when the EAT takes title to the relinquished property.
  • Within 45 days after taking title of the parked property, the taxpayer must formally identify the replacement property to be acquired.
  • The EAT and the taxpayer must complete a Qualified Exchange Accommodation Agreement.

When A Forward Reverse Exchange Is Useful

  • The lender on the replacement property will not allow the taxpayer to finance/take the title in the EAT's name.
  • The owner of the investment property listed for sale finds the ideal replacement property before finding a buyer for the exchange property.
  • The real estate investor needs to buy prime real estate as it enters the market.
  • Real estate sellers wish to avoid identifying replacement property in the 45 days required by a 1031 exchange.

Improvement Exchange

In an Improvement or Construction Exchange, the proceeds from the relinquished property sale are used to acquire the replacement property and make the desired improvements. This exchange is also known as a “Build-to-Suit” Exchange. The property must be held (parked) by an Exchange Accommodation Titleholder (EAT). The EAT must hold the property until either the improvements are completed, or the 180-day exchange deadline occurs. On or before the 180th day, the improved property must transfer to the exchanger as the replacement property.

These transactions may also be structured as Reverse Improvement Exchanges. Please contact us to discuss your specific situation as these transactions are complex.

Improvement Exchange Rules

  • Improvement exchanges have a 180-day deadline starting on the sale of the relinquished property.
  • Within 45 days of closing on the sale, the taxpayer must formally identify the replacement property(s) and desired improvements.
  • EAT must take title to the replacement property while the improvements are made. (If the taxpayer were to take title to the replacement property, the value of the improvements would not be sheltered in the exchange).
  • The EAT and the taxpayer must complete a Qualified Exchange Accommodation Agreement.

When an Improvement Exchange Is Useful

  • The taxpayer is in the 45-day identification period and finds replacement property that is significantly lower than the Net Selling Price (NSP) of the relinquished property, but the property needs work/improvements.
  • The taxpayer can use the Improvement Exchange to equalize the exchange value by including the value of improvements made to the replacement property.

Reverse Improvement Exchange

Reverse Improvement Exchanges allow the taxpayer to acquire the replacement property before closing on their relinquished property. These exchanges incorporate improvements to the replacement property to increase the property's value.

Reverse Improvement Exchange Rules

  • An EAT must take title of the replacement property and hold the title while the improvements are made.
  • Reverse improvement exchanges have a 180-day deadline. The 180-day countdown starts on the date the EAT buys the replacement property for the taxpayer/seller.
  • Within 45 days after the purchase of the parked property, the taxpayer must formally identify the relinquished property.
  • The EAT and the taxpayer must complete a Qualified Exchange Accommodation Agreement.

When an Improvement Exchange Is Useful

  • The taxpayer is in the 45-day identification period and finds replacement property significantly lower than the Net Selling Price (NSP) of the relinquished property, but the property needs work/improvements.
  • The taxpayer can use the improvement exchange to equalize the exchange value by including the value of improvements made to the replacement property.

1031 Exchange Rules

Net Selling Price (NSP)

To avoid capital gains tax on the sale of your relinquished property, you must spend an amount equal to or greater than your net selling price. (NSP equals selling price minus title fees and realtor commissions)

180-Day Rule

You must close on one or more of your identified replacement properties within 180 calendar days of closing on your relinquished property.

What Properties Qualify

You can exchange all real estate as long as you hold it for investment or productive use in a trade or business. House=Duplex=Land=Condo=Business Land=30-Year Lease=Deed for Deed

What Properties Qualify

You can exchange all real estate as long as you hold it for investment or productive use in a trade or business. House=Duplex=Land=Condo=Business Land=30-Year Lease=Deed for Deed

You Must Use a Qualified Intermediary (QI)

The regulations state that you use a QI to conduct your exchange. Your QI does three main things. First, they prepare the exchange agreement. Second, they escrow the proceeds after closing on the relinquished property. Third, they coordinate the exchange with all closing agents.