Many real estate investors are choosing a reverse 1031 exchange to reduce risk. This article explains what it is and how it’s different than a regular 1031 exchange transaction.
Long story short, you’ll need to hire a great qualified intermediary to pull this off. Some 1031 exchange companies don’t specialize in reverse 1031 exchanges. Make sure you ask about their experience conducting reverse 1031 exchanges before you sign anything. We wrote a guide about how to find a qualified intermediary.
What is a Reverse 1031 Exchange? An Overview
A reverse exchange is easier than it sounds – instead of selling your old property then buying a new one, you buy a new property before your old property is sold.
This is used commonly in seller’s markets where there is more demand for properties than supply. It also reduces the risk that you don’t find a good new property 45 days after selling your old property.
That may seem easy, but there are more hoops to jump through compared to a regular 1031 exchange. First, you cannot hold the title of the future property yourself when you purchase. The title has to be held (or parked) by an Exchange Accommodation Titleholder (EAT) through the process for tax reasons. You will need a qualified intermediary. They will transfer the title from your previously owned home to the buyer, and transfer the title for your new property to you.
There are many examples of reverse 1031 exchanges and they broadly fall into two types: Safe-Harbor Reverse exchanges, and non-safe harbor reverse exchanges. Both are legal, but safe-harbor exchanges have been defined clearly by the IRS in Revenue Procedure 2000-37. To learn more about the different types of reverse 1031 exchanges and how it can benefit you, read below.
Reverse 1031 Structure – Exchange Last
The most common safe-harbor reverse exchange is called an “Exchange Last” structure. In this example, you instruct a qualified intermediary to purchase the future property on your behalf. Once your old property is sold, the qualified intermediary will deed the purchased property back to you.
The issue that may arise with an “exchange last structure” is with your lender. They may be concerned with another entity holding the future property since it is usually the collateral for the loan. This is another reason to involve a qualified intermediary early in the process as a conference call between you, the QI, and your lender will be necessary to ensure your lender is willing. You also may need to speak with multiple lenders, or your qualified intermediary may have recommendations.
Reverse 1031 Structure – Exchange First
More uncommon, an exchange first structure is easier to get financing for. The drawback is you don’t have as much flexibility to find and finance the future property you are looking to acquire. In a nutshell, you acquire the new property up front with funds directly from your lender, and you immediately transfer the title of your old property to your qualified intermediary.
The issue with an exchange first structure is that you have to come up with the down payment for the future property before you can sell your old property.
Separate Special Purpose Entity
An alternative is to direct a qualified intermediary to set up an LLC to park the title to your property. Special Purpose Entities are used in corporate finance and reinsurance firms to keep assets separate from the rest of an organization. This is completely legal but does require a qualified intermediary to pull off. Contact us for recommendations on a qualified intermediary with previous experience setting up a separate special purpose entity.
Why do a reverse 1031 exchange and what’s the advantage?
- You may find a property that you need to purchase quickly and had not thought about selling your current property
- The sale of your current property could have issues and you don’t want to miss out on the property you are looking to purchase
- Investors choose to do a reverse 1031 exchange because it’s less stressful to find a new property within the 45-day timeline. By looking for new properties first, you have less risk of making a bad deal!
Reverse 1031 Exchange Timelines
The deadlines to complete a reverse 1031 exchange are similar to a regular exchange, but in reverse. 45 days to identify the property you are going to sell and a total of 180 days to complete the sale of your property. Many investors prefer the flexibility of finding the property up front. This is because it’s harder to find a good real estate deal than to sell a property slightly below market.
As you can see from the graphic above, day 1 of the exchange is on the day you close on the new property. Usually, the first day kicks off the most stressful part of the process, the identification period. In a typical 1031 exchange, you would need to identify a property you’re intending to buy.
Instead, under a reverse 1031 exchange, you only have to identify one of your existing properties to sell. This is much easier, as I’m sure you already have an idea which property will go. This is the big advantage of the reverse 1031 exchange.
After you’ve identified the property you’re going to sell, you must close on the sale within 180 days. This is usually not an issue, since you can list the property at market value or slightly lower to ensure a quick sale.
Reverse 1031 Exchange Cost
Reverse 1031 exchanges do require more time for paperwork and logistics and cost more to complete. There is IRS reporting on ownership of the bought and sold properties (while it is in escrow) and accommodation fees. It is important to consider the potential capital gains savings from a reverse 1031 exchange. Some owners with less than $500,000 in capital gains choose a regular 1031 exchange because of this.
A regular 1031 exchange typically runs between $750-$1,000. We commonly see Reverse 1031 exchanges start at $3,500 and increase in cost with size and complexity of the transaction. It usually makes sense for capital gains over $500,000 or if you require the flexibility to find the replacement property before selling your old property.
Part of the reason the reverse 1031 exchange cost is higher than a typical exchange is because there is no interest income for the qualified intermediary. In a typical exchange, you sell a property and the funds are held by the QI, accruing interest. For $500,000 sitting in a bank account for 180 days at 2% interest, that’s a $5,000 gain. In a reverse 1031 exchange, there is no waiting period between the property sale and replacement purchase. This is why QI’s charge more for reverse exchanges.