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How Does a Reverse 1031 Exchange Work in Real Estate?

Updated: May 6

There are 19.9 million rental properties. Individual property investors, as opposed to corporate owners, own 70% of rental properties.

It seems one goal of many is to be a property investor. The reason for property investment is, of course, to grow your real estate portfolio over time.

One way investors can do this is by using a 1031 property exchange or a reverse 1031 property exchange. Astute investors use this method to reinvest dollars that would be paid in taxes for their own benefit.

Real estate investors can defer paying capital gains taxes using one of these exchange options. While there are benefits to using these exchanges, the rules are strict and must be followed exactly to reap the benefits.

Read on to learn more about a reverse 1031 exchange.

What Is a Reverse 1031 Exchange?

To understand a reverse 1031 exchange, you must first understand some fundamentals of a 1031 exchange. These are commonly called like-kind exchanges.

A 1031 exchange allows a real estate investor to sell one property, then direct the Qualified Intermediary to purchase a replacement property. If the numbers meet the rules of the exchange and there is no "boot," this will allow the investor to defer paying capital gains taxes.

Of course, some stringent timelines and IRS rules are associated with a 1031 exchange. One of those rules is how long you have to identify and purchase the replacement property. What's unique about a reverse 1031 exchange is that the investor actually purchases the replacement property before going through the process of selling the relinquished property.

However, the IRS doesn't allow an investor to own both properties simultaneously. You might wonder then how it's possible to do a reverse 1031 exchange and buy the replacement property before relinquishing the original property.

Let's look more closely at the IRS rules for this scenario.

Rules for a Reverse 1031 Exchange

The IRS doesn't allow a real estate investor to technically own both pieces of real estate at the same time. They've created safe harbor laws, including a safe harbor under Rev. Proc. 2000-37.

The first thing to remember for a reverse 1031 exchange is that it can only be done with a like-kind property. Investment real estate, such as rental properties, vacation homes, apartment buildings, and land, all qualify. A primary residence isn't like-kind to property held for investment purposes.

A 45-day identification period to name the relinquished proeprty/s to be matched up with your purchase still applies. Additionally, the 180-day time frame must be adhered to for the completion of your relinquished property sale and transfer of title from the QI to the Exchanger.

Finally, a property of equal or greater in value must be acquired. The net equity from the relinquished property should be matched with a similar amount invested into the replacement property. Debt on the replacement property needs to equal or to the debt given up on the relinquished property.

How a Reverse 1031 Exchange Works

The real estate exchanges happen a little differently in a reverse 1031 exchange. It allows the real estate investor to act quickly to get a desirable property and then focus on selling the original property.

The reverse exchange involves using an exchange accommodation titleholder (EAT). An LLC is created for each specific exchange and goes on

title to the property acquired. The QI holds the acquired property until the relinquished property is sold.

The investor needs to make sure that the equity used to buy the replacement property is more than the amount of net equity in the property being sold. The amount of money used to acquire the replacement property is treated as a loan from the Exchanger to the Qualified Intermediary. This loan will be paid back to the client when the relinquished property is sold.

Ideally, the loan payoff on the relinquished property will use all the proceeds from the sale. If there are excess proceeds after the reverse loan payoff, those dollars can be used to buy another replacement property in a straightforward exchange. The Exchanger can also elect to take excess proceeds from the sale, but that would be a taxable event.

Additionally, a loan on the replacement property can create issues with holding title by the Qualified Intermediary. It can put the numbers for the transaction out of balance and cause some boot for the Exchanger. Careful planning of the numbers is mandatory to have a properly constructed reverse exchange.

Understanding Real Estate Exchanges

A reverse 1031 exchange allows an investor to quickly grab a desirable property that might become available. They can still garner the tax benefits of a 1031 exchange and delay the payment of capital gains taxes.

Investors must follow the rules exactly in a 1031 exchange. If you want help understanding the process or need to find an experienced QI, we can help. Contact us today to learn more about the 1031 exchange process, specifically the reverse exchange process.

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