Reverse 1031 Exchanges
April 24, 2024 - Publication
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Many real estate investors are familiar with a 1031 exchange, wherein a taxpayer may be able to defer the recognition of taxable gain on the sale of real property held for business or investment purposes by acquiring replacement real property. An alternative to a standard “forward” 1031 exchange is the concept of a “reverse” 1031 exchange. In a reverse 1031 exchange, replacement property is acquired prior to the sale of the relinquished property. This contrasts with a typical forward 1031 exchange, where the relinquished property is first sold, and either contemporaneously with or after which a replacement property is identified and acquired.
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Like a forward 1031 exchange, several key requirements must be met to successfully execute a “reverse” 1031 exchange. These requirements include:
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Qualified Intermediary: Just like in a forward 1031 exchange, the taxpayer must engage a qualified intermediary (QI) to facilitate the exchange. The QI will assist in coordinating the transaction and ensure compliance with IRS rules and regulations throughout the process.
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Exchange Accommodation Titleholder: Under Section 1031, the taxpayer cannot own or hold title to both the relinquished property and the replacement property at the same time or the exchange will fail. Therefore, an Exchange Accommodation Titleholder (EAT) is used in reverse 1031 exchanges to temporarily hold title to one of the properties for the duration of the exchange period. The QI sets up the EAT in the form of a single-member LLC. Then, the taxpayer and the EAT must enter into a Qualified Exchange Accommodation Agreement outlining the terms and conditions of the exchange as required by Revenue Procedure 2000-37. Of note, the need for an EAT makes a reverse 1031 process pricier than a typical forward 1031 exchange.
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Identification Period: The IRS imposes strict timeframes for identifying both the relinquished property and the replacement property. In a reverse exchange, the taxpayer must identify the relinquished property within 45 days of closing on the replacement property. This is typically done through the QI.
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Exchange Period:The IRS allows a total exchange period of 180 days for the entire transaction, encompassing the acquisition of the replacement property and the subsequent sale of the relinquished property. This includes the 45-day identification period.
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Like-Kind Property: To qualify for a 1031 exchange, both the relinquished property and the replacement property must be used for business or investment purposes. Personal-use property does not qualify for a 1031 exchange.
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Equal or Greater Value: The replacement property’s value must be equal to or greater than the relinquished property’s value to fully defer capital gains tax. This means that the equity and the debt in the replacement property must be equal to or greater than the equity and debt in the relinquished property. If the replacement property’s value ends up being less than the relinquished property’s value, the difference is known as “boot” and will be currently taxable in the year of sale of the relinquished property. The potential for boot becomes particularly relevant in a reverse 1031 exchange, given that the actual value of the relinquished property may not be known at the time of purchasing the replacement property.
- The benefits of a reverse 1031 exchange are generally a function of a taxpayer’s ability to close on the replacement property without having to first sell the relinquished property. In a competitive real estate market, a purchaser’s desire to delay the closing on a purchase in order to first sell the relinquished property may result in the loss of the opportunity to purchase the desired replacement property. Therefore, a reverse 1031 exchange can be extremely valuable in this circumstance.
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The risks of a reverse 1031 exchange are generally a function of compliance with the required strict timeline surrounding the exchange, as well as the financing component of such a transaction. A taxpayer must find a qualified buyer for the relinquished property, negotiate an acceptable sales price, and close on the sale transaction, all within 180 days of the closing on the acquisition of the replacement property. Moreover, financing for the acquisition of the replacement property can be complex in a reverse 1031 exchange because of the fact that the taxpayer would need to secure financing for the purchase before selling the relinquished property in that the replacement property is acquired first.
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It’s important to consult with tax professionals and legal advisors experienced in reverse 1031 exchanges to navigate the process successfully and ensure all the requirements are met. Additionally, the rules and regulations governing 1031 exchanges can change over time, so staying current with tax law is necessary. For legal or tax advice on a specific reverse 1031 exchange matter, please contact Levun, Goodman & Cohen, LLP.
