For many real estate investors, there is great happiness when a property is sold for a profit. But, a profitable sale is a double edged sword. Investors are happy because they made a profit, but their enthusiasm may be dampened when they get the tax bill because of the profit. The good news is, there is a commonly used mechanism to defer the taxes due on a profitable sale – it is called a 1031 exchange. There are different types of 1031 exchanges, and one that investors are starting to ask more about is the reverse 1031 exchange.
In this article, we are going to describe what a reverse 1031 exchange is, how it works, and the risks and benefits of utilizing this program. By the end, readers should have the information needed to determine if a reverse 1031 exchange is a good fit for their individual circumstances.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As such, we have a significant amount of experience assisting investors with placing their 1031 exchange funds. If you are an Accredited Investor, looking to place 1031 exchange funds, and would like to learn more about our current investment opportunities, click here.
What is a Reverse 1031 Exchange?
A 1031 exchange is a tax deferral program that allows investors to defer capital gains taxes on the profitable sale of an investment property. A “reverse” 1031 exchange means that the investor purchases the replacement property first, and then sells their property second.
The most common form of 1031 exchange is the “delayed exchange,” where the owner sells their property first and then uses the proceeds to purchase the replacement property. But, it doesn’t always happen this way. There are a number of reasons why a reverse 1031 rxchange would be used instead, but the most common is that an investor finds a property they like, buys it first, and then initiates the 1031 exchange process.
1031 exchange is named after section 1031 of the Internal Revenue Code (IRC), which defines the rules that allow it. While there are several eligibility requirements, the most important point is that it allows investors to defer capital gains taxes as long as they reinvest the proceeds from the sale of the “relinquished property” into a new property (the “replacement property”) that is considered to be “like kind” to the sold property. The rules around “like kind” are fairly broad and most commercial real estate is generally considered to be like kind to other commercial real estate.
There is also a time component to the 1031 exchange rules. Under IRS rules, the taxpayer (investor) must identify their replacement property within 45 days of sale and close on the purchase of it within 180 days. At first glance, this may seem like a lot of time, but the competition for the best replacement properties can be stiff, and finding one at the right price and within this time frame can be a real challenge.
Sometimes, investors find a replacement property before they have even closed on the property that they plan to sell. If they like it enough, they may jump to put it under contract and complete a “reverse 1031 Exchange” instead.
To further illustrate how this process works, the steps of a reverse 1031 exchange are described below.
Steps Involved in a Reverse 1031 Exchange
Every real estate transaction is unique, but a reverse 1031 exchange is typically completed in six steps.
Step 1: Qualified Intermediary or Exchange Accommodator Titleholder Agreement
In the first step of a reverse 1031 exchange, the investor identifies an “Exchange Accommodator Titleholder” – EAT for short – whose job is to hold the title to the replacement property until the exchange process is complete. To consummate their relationship, the Exchanger and the EAT enter into an agreement known as a “Qualified Exchange Accommodation Agreement” or QEAA for short.
Step 2: Buy The Property
Once the QEAA is in place, the next step in a reverse exchange is for the exchanger to purchase their replacement property. The property can be any type that is considered to be “like kind” and must have equal or greater value to qualify for full tax deferral. As part of the purchase process, the exchanger may work with a lender to finance at least some portion of it.
Step 3: EAT Takes Possession of Title To The New Property
Once the purchase transaction is closed, the title to the property is transferred to the EAT. Again, their job is to hold it and keep it safe, under the terms of the QEAA, until the 1031 Exchange is complete.
Step 4: Exchanger Identifies the Relinquished Property
Often, an exchanger may have more than one property to be sold. When this is the case, they must determine which one of them that they want to sell. Usually, they have this in mind prior to purchasing the replacement property, but not always.
It is important to note that there is a time component to the identification of the relinquished property in a reverse 1031 exchange. It must be identified within 45 days of the close of the purchase of the replacement property. The formal identification is made in writing.
Step 5: Choose a Qualified Intermediary
A qualified intermediary – QI for short – is an expert in 1031 exchange rules and they work on behalf of the exchanger to make sure they are followed. If any part of the transaction does not comply, there could be tax consequences.
Step 6: Sell The Relinquished Property
Finally, the last step in the process is for the exchanger to sell the relinquished property. There is also a time component involved in this step and it requires that the sale of the relinquished property occurs within 180 days of the purchase of the replacement property.
Once the old property is sold, there is some final exchange work to be completed before it is finalized. Once it is, the property title is transferred and the exchange is complete.
Time Period For a Reverse 1031 Exchange
The reverse 1031 exchange transaction has time constraints within which it must be completed. There are two important reference points to be aware of.
45 Days
In a reverse exchange, the taxpayer must identify the relinquished property to be sold within 45 days of the purchase of the replacement property. Identification takes place in writing and it is a crucial moment in the exchange period.
180 Days
In a reverse 1031 exchange, sale of the relinquished property must be completed within 180 days of the purchase of the replacement property. This requirement is potentially the riskiest part of a reverse exchange because there is no guarantee that the property will sell, let alone within the required time period. If it doesn’t, it could expose the exchanger to some degree of tax liability. As a result, they need to be reasonably certain that their property will sell within this 180 day time period.
Rules of Reverse 1031 Exchanges
A 1031 exchange can be a complicated transaction because there are many rules that investors must abide by. These rules are outlined in the legal text governing 1031 exchanges, and there are many of them. A few of the most important are described below.
Property Value
The property value of the relinquished property must be equal to or greater than the Replacement Property. In addition, the amount of equity must be equal or greater.
For example, if an investor purchased a property for $1MM and used $500,000 in debt, they must exchange at least $500,000 in equity into a property that has a market value of $1MM or higher.
If there is a difference between these two amounts, it is known as “boot” and it is taxable.
Property Type
The relinquished property must be “like kind” to the Replacement property, which is why a 1031 exchange is sometimes referred to as a “like kind exchange.”
There are rules around what qualifies as like kind, and it is safe to assume that commercial real estate is like kind to other commercial real estate. For example, a multifamily apartment building could be considered like kind to a grocery store anchored retail center. A commercial property is not usually like kind to a residential property such as a primary residence.
The Qualified Intermediary can help by making sure that the “like kind” test is met.
Number of Properties
Based on the description of it, many investors assume that there must be a 1:1 relationship between properties in a 1031 Exchange. This is not necessarily the case. Depending on the investor’s objectives, there can be a many to one relationship between properties, which can allow investors to diversify their portfolio. For example, an individual could exchange one office property with a retail property and an industrial property…but the values must line up. There are two rules with regard to this:
- The “200% rule” states that an investor can identify as many properties as they want as long as the combined value does not exceed 200% of the Relinquished Property’s value.
- The “95% rule” states that an exchanger can identify as many properties as they want as long as they close on, and acquire, at least 95% of the value of the properties identified.
This is another area where the services of a Qualified Intermediary are helpful because any violation of either of these rules can result in a surprise when it comes time for an exchanger to file their tax return.
Time
Once again, time is an important consideration in a reverse 1031 exchange. Investors have 45 days from the purchase of the Replacement Property to identify which properties in their portfolio are going to be sold and 180 days to complete the sale. This timeline highlights one of the unique risks of a reverse 1031 exchange because there is no guarantee that the relinquished property sells. If it doesn’t, the property owner could run into some unanticipated headaches.
Like-Kind Properties for a Reverse Exchange
There are two tests with regard to properties used in a reverse 1031 exchange.
The first is that they must be “like kind.” Again, most commercial property is like kind to other commercial property, so the exchange is less complex. It can become far more complex if an individual attempts to use their primary residence or vacation house as an exchange property. This is not to say that it cannot be done, but there are certain requirements that make it more complex.
The second test is that the property must be “held for productive use in a trade, or for business or investment.” This is why it is difficult to exchange a primary residence – it is not a business property -but there are certain circumstances or scenarios where it may be possible, however complex.
Why Investors May Consider a Reverse 1031 Exchange
In general, a 1031 exchange is useful for tax purposes. Specifically, a reverse exchange may be useful because it can be challenging to find a replacement property within the allotted time period. So, the main motivation behind a reverse 1031 exchange is if the investor finds the property first.
Summary of Reverse 1031 Exchanges
A 1031 exchange is a program that allows investors to defer taxes on the profitable sale of an investment property as long as they reinvest the sale proceeds into another property that is considered to be “like kind.”
In a traditional 1031 exchange, an investor sells a property first and then uses the proceeds to purchase a replacement property.
In a reverse 1031 dxchange, the replacement property is purchased first and then the relinquished property is sold. There are a number of reasons an investor might do this, but the most prominent is that they find a property they like and want to purchase it immediately.
There are a number of rules that investors must adhere to when completing the exchange, and they have to happen in a specific order, but the most important have to do with time and the values of the exchanged properties.
Because the rules can be complex, it is always a good idea to work with a qualified intermediary to complete the exchange. They work on the investor’s behalf to make sure all rules are followed. If the rules aren’t followed, there may be a taxable event.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
