When investing in real estate, you need to understand carefully all the rules and regulations that are applied to the trade. These include the Reverse 1031 Exchange.
You may have heard of this Internal Revenue Service code, but what does it exactly mean? In this article, we will discuss what is a Reverse 1031 Exchange, the rules that come with it, and how to take advantage of it when buying and selling properties.
Reverse 1031 Exchange Definition
As previously implied, the Reverse 1031 Exchange is a rule implemented by the IRS to guide real estate investors. According to the code, if you want to sell a property that you have owned for less than ten years, you will be taxed on any gains made from the sale.
However, if you reinvest those gains into another “like-kind” property within a specific time frame, you can defer paying taxes on the sale. This is what’s known as a “reverse exchange”.
Types of Reverse Exchanges
Generally speaking, there are two main types of reverse exchange real estate investors can use: safe harbor and non-safe harbor.
The main difference between the two is that, with a safe harbor exchange, the taxpayer has 45 days to identify the replacement property and 180 days to complete the purchase.
With a non-safe harbor exchange, there are no time limits on identifying or purchasing the replacement property.
These reverse exchanges can be beneficial for taxpayers because it allows them to defer capital gains taxes that would otherwise be due upon selling the original investment property.
It also gives investors more flexibility in choosing what replacement property to purchase.
Reverse 1031 Exchange Rules and Requirements That You Should Know
It’s important to note that there are a few policies that come with reverse exchanges. Here are the Reverse 1031 Exchange rules 2022 investors should keep in mind.
The Property That Is Being Exchanged Must Be “Like-Kind”
This means that the property you are selling must be of the same nature, character, or class as the property you are looking to purchase. For example, you can exchange a vacant lot for another vacant lot, or an apartment complex for another income-producing rental property.
You cannot exchange a residential property for a commercial one.
Investors Must Use a Qualified Intermediary (QI) to Facilitate the Transaction
A QI is defined as a person or company who enters into a written agreement with the taxpayer to hold title to the relinquished property and then transfer it to the buyer. They cannot be the taxpayer, the person acquiring the replacement property, or related to either party. They must also be qualified and licensed to do this type of work in the state where the property is located.
It’s important to note that if you don’t use a QI, the IRS will not allow you to defer paying taxes on your capital gains.
Both Traded Properties Must Be Held for Investment
This means that you cannot exchange a personal residence for another property. The IRS considers personal residences to be held for investment or use in a trade or business.
Simply put, the properties must not be used for personal use.
The Taxpayer Must Not Have Control of the Replacement Property Before the Exchange
The QI must have control of the replacement property before the taxpayer can take possession of it. This is to prevent investors from trying to game the system by using a reverse exchange to purchase a property that they already had their eye on.
How Does a Reverse 1031 Exchange Work
Now that you know what a Reverse 1031 Exchange, it is time to learn the process. In order for this rule to work on your end, you must follow these three simple steps.
- Identify the property that you want to purchase.
You must identify the replacement property within 45 days after the sale of the original investment property.
This can be done by sending a letter to the QI with the following information:
- The address or a legal description of the property
- The date by which you plan to acquire it
- Your intent is to use it for investment or trade purposes
If you are unable to identify a replacement property within this time frame, you will not be eligible for the exchange’s tax benefits.
But again, if you use a non-safe harbor exchange, there are no time limits on identifying the replacement property.
- Find an exchange accommodation titleholder (EAT) who is willing to hold the title of your new property until the sale of your old one is complete.
The EAT can be a friend, family member, or even the QI themselves. They must be willing to accept title to the property and then transfer it to you on the date of the sale.
However, it would be better if they are not related to you, so that there is no conflict of interest. They will also need to sign a letter of intent that outlines their agreement to act as the EAT. This document will need to be signed by both parties and notarized.
- Purchase the replacement property using funds from the sale of your old investment property.
Once the sale of your old property is complete, the funds will be transferred to the EAT. They will then use those funds to purchase the replacement property on your behalf.
You will then take over ownership of the new property once the sale is complete. And that’s it! You have successfully completed a reverse exchange.
Reverse 1031 Exchange Timeline
In any case, the standard timeline for a regular exchange is the same as the standard Reverse 1031 Exchange timeline. This means that you have 180 days from the date of the sale of your old property to complete the purchase of the new one.
The only difference is that in a regular exchange, you must first sell your old property before you can purchase the new one. In a reverse exchange, the order is reversed, and you must first purchase the new property before selling your old one.
This may seem like a small distinction, but it can make all the difference when it comes to timing.
Which Types of Properties Does the Reverse 1031 Exchange Apply To
The 1031 Exchange rules do not only apply to a particular type of property. It can be applied to all real estate investment properties, including residential, commercial, and net lease properties, such as triple net leases (NNNs).
For Residential Properties
For these properties, the most common type of exchange used is the Delayed Exchange. In this type of exchange, the EAT purchases the replacement property on your behalf and then leases it to you until the sale of your old property is complete.
The advantages of using a delayed exchange for residential properties are that it gives you more time to find a suitable replacement property and that it allows you to live in the new property while still owning your old one.
For Commercial Properties
In this case, the most common type of exchange applied is the Construction Exchange. In this method, the EAT purchases the land on which you plan to build your new property and then transfers it to you once the construction is complete.
The good thing about using a construction exchange for commercial properties is that it allows you to start construction on your new property before selling your old one. This can be a major advantage if you are planning to build a new office or retail space, as it will allow you to move in and start operating sooner.
For NNN Properties
NNN properties can also be exchanged using the reverse exchange method. In this situation, the EAT purchases the replacement property on your behalf and then leases it to you under a triple net lease agreement.
The perk of using a reverse exchange for NNN properties is that it allows you to purchase the property and then lease it back to the tenant, which can provide you with a steady stream of income.
For more information on how this rule applies to net lease properties, you can read this Reverse 1031 Exchange guide by one of the most trusted investment mentors in the industry.
Conclusion
Reverse exchanges can be a great way to save on taxes when you are selling and buying investment properties. However, it is important to remember that this rule does not apply to all types of properties.
If you are planning to sell and buy an investment property, be sure to consult with a qualified tax advisor or real estate attorney to ensure that a reverse exchange is applicable.
This concludes our guide on what is a Reverse 1031 Exchange. We hope that you found this article helpful and that it will help you with your real estate business. Thank you for reading!
Reference:
Falkenbach, Heidi, Anna-Liisa Lindholm, and Helmut Schleich. “Review articles: environmental sustainability: drivers for the real estate investor.” Journal of Real Estate Literature 18.2 (2010): 201-223.
