In today’s market, investors want the ability to buy profitable real estate assets promptly. If using a 1031 exchange, you must sell your current investment property before purchasing the replacement property. But, what if you find a new investment property before you sell the old? You don’t want to miss your chance at scooping up a great deal. Enter the reverse 1031 exchange.
In a typical 1031 exchange, you sell your current property first. Then, you have 180 days to reinvest the profits from the sale into a new property. This exchange defers capital gains and other taxes. The sale of the relinquished property occurs before the purchase of the new property.
A reverse 1031 exchange allows the opposite to occur. Working within specific guidelines, investors can acquire replacement property before selling their current property. This transaction also allows deferment of all capital gains and other taxes, similar to a standard 1031 exchange.
How does a reverse 1031 exchange work?
Reverse exchanges allow investors to purchase a replacement property before selling the soon-to-be relinquished property. You cannot simultaneously hold title to both the new property and the property you want to sell. There are several IRS rules your transaction must comply with to start and complete a successful reverse exchange. It is crucial that you be well-versed in IRC Section 1031 that governs all exchange transactions.
With that said, below are a few pointers regarding reverse exchanges. These provide you an idea as to whether these investing techniques are right for you:
There are two types of reverse exchanges.
- An “exchange last” transaction allows an Exchange Accommodation Titleholder (EAT) to take title to the newly purchased property.
- The “exchange first” option enables the EAT to take the sale property title before purchasing the new property.
Either transaction requires an EAT to park one of the properties. Parking one of the properties prevents the investor from holding the title to both properties simultaneously. The IRS formed guidelines for reverse exchanges within their “safe harbor” rule defined in Revenue Procedure 2000-37. In either type of reverse 1031 exchange, a 180-day deadline applies for the transaction.
Reverse 1031 Exchange Steps
- You go under contract for the property you wish to purchase. Make sure that the contract is assignable because the title will be going in the LLC.
- Next, forward Midland 1031 a copy of the purchase contract and the title company’s or attorney’s contact information. If there is a mortgage on the property, we will need to know the lender’s contact details. You will need to notify the lenders immediately to let them know you’re doing a 1031 exchange. The loan documents will need to be in the name of the LLC established for the exchange.
- Then, Midland 1031 sets up the LLC that will take title to the property. We will provide closing instructions to the title company or attorney handling the closing.
- You must then identify all potential sales for the exchange to your QI within the first 45 days of the 180 days.
- Once you are under contract to sell your original property, Midland 1031 draws up the transaction documents on your sale. We then forward closing instructions to the title company handling the closing.
- You would proceed with the closing, and the title company would wire the proceeds directly to us. We would then use the proceeds 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 your sale, we assign full membership in the LLC to you. You will now be the owner of the new property.
Rules for reverse exchanges
- All parties involved must receive notification that the sale/purchase of the investment property is part of a reverse 1031 exchange.
- You must use a qualified intermediary (QI) such as Midland before purchasing the replacement property. The QI will ensure the new property is titled correctly.
- The QI establishes an LLC, which takes title to either the new property or the soon-to-be-relinquished property. Note: the LLC is the EAT.
- In “exchange last” transactions, the EAT takes title to the replacement property at closing. The “exchange first” allows the EAT to take title to the nearing relinquished property before the investor purchases the new property.
- The EAT owns the parked property and is considered the property owner for tax purposes. However, the EAT does not have the advantages or obligations of owning the property.
- The investor pays all expenses for that property and collects all income produced until the reverse 1031 exchange is complete.
There are additional requirements for each type of reverse exchange other than the 180-day rule. So, before you do any 1031 exchange, check with your lender, tax advisor, and a qualified intermediary. Reverse 1031 exchanges are incredibly beneficial but are also somewhat complex. To reap the benefits, you must ensure compliance with all rules and regulations.
For additional and more detailed information about reverse 1031 exchanges, call Midland today at 239-333-1031. Or, click here to schedule a free consultation. Our Certified Exchange Specialists® (CES®) explain the process and guide you through every exchange step.