The 1031 exchange, often referred to as a like-kind exchange, is a powerful tax strategy that allows real estate investors to defer capital gains taxes on the sale of one property by reinvesting in another property of equal or greater value. While the traditional 1031 exchange involves selling your current property first and then identifying and acquiring a replacement property, there’s another lesser-known approach called the reverse 1031 exchange. In this blog, we’ll explore the concept of a 1031 reverse exchange, its benefits, and the rules and guidelines that must be followed to execute it successfully.
A 1031 reverse exchange is a tax-deferral strategy that allows real estate investors to acquire the replacement property before selling their relinquished property. In a traditional 1031 exchange, the process typically starts with selling the relinquished property and then identifying and acquiring the replacement property within specific timeframes. In contrast, a reverse exchange flips this sequence.
In a reverse exchange, an investor acquires the replacement property first, using a special purpose entity ( referred to as an Exchange Accommodation Titleholder or EAT). The EAT holds title to the replacement property under the terms of a qualified exchange accommodation agreement (“QEAA”). Once the sale of the relinquished property or properties is complete, the taxpayer completes the exchange into the replacement property. The IRS has created a “safe harbor” for reverse exchanges, which means a taxpayer can engage in this type of transaction with the confidence that the IRS will not challenge the tax deferral.
A reverse exchange allows a taxpayer to acquire a desired property prior to completing the sale of an existing property. The reverse exchange also allows the taxpayer to designate multiple relinquished properties, with either some or all being included in the desired exchange. This strategy is particularly useful in a seller’s market where finding suitable replacement property is more challenging than disposing of the taxpayer’s current property.
Investors often use reverse exchanges to make improvements to the replacement property while held by the EAT. This strategy allows the investor to add the value of qualified improvements to the acquisition cost of the replacement property, which in turn increases the total value of the property, which can increase the tax deferral.
A reverse exchange can help investors lock in a favorable replacement property in a volatile real estate market before market conditions change. This can be especially valuable when the investor believes that prices or interest rates may rise.
There are multiple reasons why a closing may be extended or delayed. A taxpayer who intends to complete a forward exchange can confidently convert to a reverse exchange without risking their tax deferral.
Revenue Procedure 2000-37 sets forth the method for completing a successful 1031 reverse exchange. Under the Revenue Procedure, the taxpayer can “park” either the relinquished or replacement property. It is easier and more common to park the replacement property. Here’s a step-by-step guide to where the replacement property is parked with an EAT:
First and foremost, consult with qualified professionals, including tax advisors, real estate attorneys, and a qualified intermediary (QI) specializing in 1031 exchanges. They will help you navigate the complex rules and ensure compliance with the IRS safe harbor regulations outlined in Revenue Procedure 2000-37.
The first step in any exchange transaction is to enter into an exchange agreement. In the reverse exchange, that agreement is referred to as a Qualified Exchange Accommodation Agreement or “QEAA.” The QEAA is between the taxpayer, the EAT, and a qualified intermediary. The QEAA sets forth the parties’ intent to perform a reverse exchange and the respective obligations. The Revenue Procedure requires the taxpayer to identify the relinquished property or properties within 45 days of the date of the QEAA and to complete the sale of one or more relinquished properties within 180 days of the date of the QEAA or the due date for the taxpayer’s return, whichever occurs first. The EAT will hold title to the replacement property during the period of time the exchange is in effect.
Under the terms of the QEAA, the taxpayer is responsible for funding the cost of acquisition of the replacement property. This can be accomplished by securing funds from a lender or, funds from the taxpayer, or a combination of the two.
The taxpayer will identify the relinquished property to the qualified intermediary (“QI”) within 45 days from the date of the QEAA.
Within 180 days of the EAT’s acquisition of the replacement property (or the due date of the taxpayer’s return, whichever occurs first, the taxpayer must complete the sale of any of the identified relinquished property. The proceeds from the sale are transferred to the QI, who applies them to purchasing the replacement property held by the EAT. In practical terms, the proceeds are disbursed at the taxpayer’s direction to reimburse funds advanced by the taxpayer to acquire the replacement property, pay down the principal on the loan used to acquire the replacement property, or a combination of the two.
At the same time that the proceeds from the sale of the relinquished property are disbursed, the QI will complete the exchange by either deeding the replacement property to the taxpayer or transferring the membership interests in the EAT to the taxpayer to complete the exchange.
Under the safe harbor regulations, taxpayers are required to file a return for the EAT. The return should reflect the appropriate items of income and expense while the property was parked with the EAT.
Getting the intended result starts with creating the proper strategy. It’s important to make sure your team has the experience and expertise to arrive at the desired result. The 1031 Exchange Intermediaries team has over 25 years of experience helping clients minimize tax liabilities allowing clients to maximize their return on investment. Our knowledge allows us to keep your improvement exchange on target.
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At 1031 Exchange Intermediaries, we have completed thousands of exchanges, including structuring reverse exchange utilizing the safe harbor established by Revenue Procedure 2000-37. Understanding the rules governing these exchanges and our client’s goals and desired outcomes is essential. We assist our clients in navigating the reverse exchange process by serving as a trusted resource and guide to reach the desired result. Let the 1031 Exchange Intermediaries team show you how our experience can help you reach your investment objectives.
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