Learn about what qualifies as an investment property in a 1031 exchange and what you can and can't do with your 1031 properties.
Can I Buy My Replacement Property Before Selling in a 1031 Exchange?
In a reverse exchange, the investor acquires the replacement property before selling the relinquished property.
You’ve decided you want to do a 1031 exchange to defer capital gains on the sale of your property. But, you found your replacement property before selling your relinquished property. If you buy the replacement property first in your name before you sell it will not qualify for a 1031 exchange.
You can still do the 1031 exchange, but for cases like this, it would be considered a reverse 1031 exchange. In a reverse exchange, a Qualified Intermediary (QI) purchases and holds your new property while you sell your existing property.
Are You Sure a Reverse Exchange is Best?
If you are certain that your replacement property must be bought now, then completing a reverse exchange is right for you. However, it’s important to note that reverse exchanges are much more complex than regular exchanges and cost substantially more. In a reverse exchange, a client still only has 180 days to complete the transaction - the same as in a regular exchange.
How does a Reverse Exchange work?
First, Midland - your QI - takes title of the replacement property in an LLC that is formed solely for the exchange. This LLC is known as the “Exchange Accommodation Titleholder” or EAT. You and the EAT must then sign a Qualified Exchange Accommodation Agreement. As the main member of the LLC, Midland signs the Exchange Accommodation Agreement on behalf of the LLC.
We are still functioning as your qualified intermediary throughout this.
We will hold that property until the existing investment property is sold. Again, the reverse exchange must be completed within 180 days. The 180-day clock starts on the date the QI purchases the replacement property for the taxpayer. Now for the tricky part: the QI is purchasing the replacement property but the client is still providing the funds.
Midland would then “park” the property in the LLC until you close on the sale of your current property. Within 45 days of purchase, a form must be completed identifying the relinquished property or properties to be sold. Once you close on your sale, we would assign full membership in the LLC over to you. This makes you the owner of the property.
To make it a little easier to understand, here’s a…
Step-by-Step Breakdown of a Reverse Exchange
- You go under contract for the property you wish to purchase. Make sure that the contract is assignable because the title will be going into the LLC. If you hold the property as joint tenants, you will need two LLCs.
- You then forward a copy of the contract with details of the title company or attorney handling the closing. The loan documents will need to be in the name of the LLC. If there is a mortgage on the property, we need to know the lender’s contact details. You must notify them immediately to let them know you’re doing a reverse 1031 exchange.
- Midland would then set up the LLC that will be taking title to the property. We will provide closing instructions to the title company or attorney handling the closing.
- You must then identify all potential properties for sale within the first 45 days of the 180-day period. This means you have to let us know directly.
- Once you are under contract to sell your original property, Midland 1031 draws up the exchange documents pertaining to your sale. We forward closing instructions to the title company handling the closing.
- You would proceed with the closing. The title company would wire the proceeds directly to us. We would then use it to pay down any loans on your new property. If there is no financing on the new property, the proceeds would be disbursed to you.
- Once you close on the sale of your original relinquished property, we assign full membership in the LLC over to you. You will now be the owner of the new property.
As you can see, a reverse exchange is a complex transaction with many steps and details. Each step must be completed in order for the exchange to qualify. In the case of outside financing, sometimes it is not possible to hold the property in the name of the EAT. In this case, you will need to discuss a “forward” or “relinquished” reverse exchange with your QI.
Reverse Exchanges are performed using guidance from Revenue Procedure 2000-37. It is required before you begin any 1031 exchange, you must notify your Qualified Intermediary before you close on any properties. One of our exchange specialists at Midland will be happy to guide you through the 1031 exchange process. Please be sure to contact us at 239-333-1031 with any questions.