Real estate investing requires a firm understanding of several technical variables. The scope of these variables extends from data analytics to various legal and fiscal aspects. Understanding how to manage taxes, in particular, can be extremely valuable to real estate investors. In this article, we will focus on one of the most effective tax deferment strategies in real estate: Reverse 1031 exchange.
Related: Real Estate Taxes: Everything a Beginner Investor Needs to Know
What Is a Reverse 1031 Exchange?
Before delving any further, we must first provide you with a simple reverse 1031 exchange definition. Tax-related concepts are often unnecessarily complicated by the use of legal jargon that confuses the average real estate investor. In reality, understanding reverse 1031 exchange is fairly simple and requires no technical prerequisites.
As stated above, the reverse 1031 exchange is a tax deferment strategy. It is the opposite of the forward 1031 exchange and its main purpose is to allow investors to defer taxes when buying an investment property. This is usually done when investors want to make another real estate investment before finalizing the sale of a relinquished investment property. The ability to defer capital gains taxes when buying an investment property is invaluable for real estate investors. This is why understanding the reverse 1031 exchange rules, timeline, requirements, and mechanisms is a must.
Related: The Tax Benefits of Real Estate Investments
How the Reverse 1031 Exchange Works
While the reverse 1031 exchange offers valuable tax benefits, it’s important to remember that it is regulated by strict guidelines. In this type of exchange, the investor has up to 45 days to pick a maximum of three real estate properties to sell after buying a replacement property. Following this, there is a 135-day deadline for finalizing the sale of the relinquished properties. The process follows the guidelines outlined by the IRS’s safe harbor guidance of revenue procedure 2000-37.
It is important to note that there are a number of requirements and restrictions that investors have to abide by. For example, you can’t hold the title of the rental property that you purchased until the exchange process concludes. Furthermore, hiring an intermediary is compulsory. This is because only qualified intermediaries can transfer titles between the two parties.
The Costs of the Exchange
Understanding the costs of the reverse 1031 exchange will give you a clear idea of what you’re getting into. As it is the case with anything in the real estate investing business, several factors influence the actual costs. Fees tend to vary from state to state and the number of properties involved in the exchange can also increase the costs in states where standardized fees are not in place.
Due to the multitude of variables at play, coming up with an exact estimate is difficult. With that being said, you can expect the costs to be in the $3000-$8000 range.
How to Do a Reverse 1031 Exchange
While a reverse 1031 exchange can be completed in a few steps, it is still highly advisable to retain the services of an advisor. This will allow you to get specific recommendations for your situation. But in the meantime, here are 8 steps to do a reverse 1031 exchange.
1- Hire an intermediary
This should be the first step of the process. Besides advising you on the proper course of action, an intermediary will be in charge of creating an Exchange Accommodator Titleholder (EAT). This is essential for managing titles and parking the properties during the exchange.
2- Enter into a Purchase and Sales Agreement with the seller
This is a type of contract that is used in complex transactions. It outlines the terms and conditions of the investment and states that the seller will relinquish ownership of the replacement property. This contract contains a number of important elements such as the full names of both parties, phone numbers, addresses, as well as the type of sale and date of the agreement.
3- Prepare closing documentation
This is typically done by the intermediary. These documents include everything from preliminary title insurance reports and escrow instructions to inspection reports and proof of insurance. The intermediary might also ask you to provide additional documentation for due diligence and pre-transaction screening.
4- Pick the property that you want to relinquish
The next step is picking which investment property you want to relinquish. Like we mentioned earlier, selling the rental property should be initiated 45 days from the purchase date of the replacement property. As for the transaction itself, you should finalize it after a total of 180 days from the purchase date.
5- Find a buyer
You need to find a buyer within 135 days of designating the real estate property that you want to relinquish. After you complete this step, a PSA with the buyer should be established. At this point, your intermediary will hold the title of the replacement property and transfer the title of the relinquished property to the buyer.
One of the most effective ways to find a buyer is to list your property on the Mashvisor Property Marketplace. This platform will help you reach thousands of potential buyers and it is extremely easy to navigate.
6- Give the deed to the new owner
To finalize the real estate transaction, you need to transfer the deed to the new owner of the relinquished property. The intermediary will oversee the transfer of the deed as well as the collection of the funds from the buyer. These funds will be used to purchase replacement property that is parked in the Exchange Accommodator Titleholder (EAT).
7- Get the deed of the new investment property
The reverse 1031 exchange concludes when the EAT hands you the deed of the replacement property.
The Basic Rules to Abide By
The rules for a reverse 1031 exchange are fairly similar to those of a regular 1031 exchange. Besides the aforementioned timeline requirements, there are some other basic rules that you need to be aware of. Here is a brief overview of the most important ones:
- The investment property that is subject to the exchange cannot be your primary residence
- Selling the relinquished property and buying the replacement property should be carried out by the same party
- Related party rules are in effect
- The value of the replacement property should be at least equal to the relinquished property
Related: 1031 Exchange – The 9 Basic Rules That You Need to Know
The Bottom Line
Navigating a reverse 1031 exchange can be quite challenging even for those who are familiar with the real estate business. This is why you should take the time to grasp every concept of the process. More importantly, consult with a qualified intermediary or a real estate agent to get proper guidance for each step of the exchange.
