Buying investment property is generally considered one of the most effective ways to make money and attain financial independence. One of the key advantages of real estate investing is that it offers incredible tax benefits. Therefore, if you want to invest in real estate, having a good understanding of real estate taxes is key to maximizing your rate of return.
If you find yourself in a position where you want to buy a new investment property before you sell your current one, there’s a tax loophole that savvy real estate investors leverage – reverse 1031 exchange.
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What Is a Reverse 1031 Exchange?
According to section 1031 of the Internal Revenue Code (IRC), investment property owners can defer capital gains taxes on like-kind exchanges of real estate. This is a provision available to investors who want to sell an old investment property and reinvest the earnings in another investment property. You can’t use it if you want to buy or sell your primary residence.
However, the problem with standard 1031 exchanges (the relinquished property is sold before the replacement property is purchased) is that it’s hard to find a seller with whom you can swipe your property directly. That’s where the reverse 1031 exchange comes in handy.
A reverse 1031 exchange is a strategy that property investors use to defer taxes when they want to acquire a replacement property before selling their relinquished property.
A reverse 1031 exchange allows you to acquire a replacement property first and then sell your current property thereafter. Though more complex, if you follow the reverse 1031 exchange rules, you can lock in decades of tax-free returns.
While the definition may sound straightforward enough, you must meet the reverse 1031 exchange requirements as outlined by the Internal Revenue Service (IRS) to avoid being taxed after the exchange of the properties.
How Does a Reverse 1031 Work?
According to the reverse 1031 exchange rules, you cannot hold the title of both the relinquished property and the replacement property simultaneously. The title of the new or old property has to be held or parked by an Exchange Accommodation Titleholder (EAT) for the duration of the reverse 1031 exchange process.
The EAT is usually a single-member limited liability company established by a Qualified Intermediary (QI). It is never reused or allowed to hold property for another exchange at the same time.
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You, the taxpayer/Exchanger, and the EAT will enter into a qualified exchange accommodation arrangement (QEAA). It’s only after the relinquished property is sold that the Qualified Intermediary will transfer the title of the relinquished property to the buyer and the replacement property to you.
Types of Reverse 1031 Exchanges
Reverse 1031 exchanges can be structured in two variations:
1. Reverse Last Reverse 1031 Exchange
With this strategy, the EAT acquires the replacement property with the financing you provide and holds or parks its title until your relinquished property sells.
This method is the most preferred because it offers more flexibility in terms of financing and structuring your reverse 1031 exchange. However, some lenders may be concerned about the EAT holding the title to the replacement property. Be sure to shop around for lenders who are okay with this reverse 1031 exchange structure.
2. Exchange First Reverse 1031 Exchange
Under this method, you acquire the replacement property yourself and simultaneously transfer the title to the relinquished property to the EAT.
While most lenders will prefer this, you’ll have less flexibility. You have to reinvest the equity trapped in your old property into your replacement property before the close of the sale. Not many will have this kind of liquidity.
How to Do a Reverse 1031 Exchange
Though the reverse 1031 exchange process is complicated, we’ll try to give you a simple overview of the steps to perform one. It’s best to seek guidance from a reverse exchange specialist before you begin the process.
- Find a Qualified Intermediary to create an EAT.
- Find a replacement property.
- Enter into a qualified exchange accommodation agreement (QEAA) with your EAT.
- The EAT acquires the deed of the replacement property and holds it for you.
- Identify the relinquished property within 45 calendar days from the date of purchase.
- Find a buyer and close the sale within 180 calendar days from the day of purchase.
- Transfer the title of the relinquished property to the new buyer.
- The EAT conveys the title of the replacement property to you.
Pros and Cons of Reverse 1031 Exchanges
Here are some of the key reasons why you should opt for a reverse 1031 exchange:
Secure a good investment property
If you have your eye on a lucrative investment property in a competitive real estate market, you can secure it before someone else acquires it. You don’t have to wait until the relinquished property sells and possibly lose out on the investment opportunity.
Minimize tax liability
If you fail to sell the relinquished property within the time limit of 180 days, you still won’t have any tax liability. With a standard 1031 exchange, if you can’t close on a replacement property after selling the relinquished property within a 45-day timeline, you would be liable to pay taxes.
Related: All You Need to Know About Investment Property Tax Deductions
While fees vary from state to state and the number of properties involved, the cost of a reverse 1031 exchange is typically much higher than that of a standard 1031 exchange. This is because they are more complicated. So you should compare the costs against the benefits to ensure that they are justified.
If you have liquid assets on hand, you are good to go. However, if you don’t have access to cash and need a loan for the replacement property, you’ll be taking a risk. Some lenders won’t approve the loan if an EAT is holding your title. Be sure to find out from the lender before you begin the process.
Risk of not selling the relinquished property
If you can’t sell the relinquished property past the 180th day, the reverse 1031 exchange will fail.
The Bottom Line
If you own an investment property that has appreciated and want to exchange it with another one you’ve identified, you can lock in the replacement property and also defer the capital gains taxes with a reverse 1031 exchange. Just make sure that you can close on a sale of your relinquished property within 180 days and that your replacement property is profitable.
Be sure to use Mashvisor’s real estate investment tools to quickly and accurately assess your replacement property’s potential return on investment.
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