Let’s be honest. You’ve probably heard about a reverse 1031 Exchange and wonder what it’s all about. Reverse 1031 exchanges are common in the real estate and property markets of the US.
A reverse exchange refers to a situation where you can first acquire new property and release the current one for sale later. The reverse transfer enables one to buy new properties now and sell later after the market prices hike.
The commercial real estate segment undergoes many changes over time. It’s advisable to diversify your real estate investment portfolio to protect your investments. Investors lose their property to short sales, foreclosures, and other distressed property deals.
The changes should present an opportunity for you to invest capital wisely.
Investors improve their opportunities for high returns by influencing real estate trends and other market conditions. The maximum grace period for holding property on delayed or reverse exchange is 180 days.
Only Section 1031 properties are eligible for reverse transactions. Businesses use 1031 exchanges to defer tax payments on acquired property. The deal is usually set up by an exchange facilitator.
Reverse 1031 Exchange: Important Factors to Consider
Parking
Parking is an IRS term that describes the EAT’s holding of the property. The method follows the Revenue Procedure 2000-37’s restriction against the Exchangor. The Exchangor shouldn’t own both the replaced and relinquished property at the same time.
In a reverse exchange, you either park the relinquished property or the replaced property. The following are the deciding factors;
- Liens
- Property and equity in the property given up
- The funding source for new property acquisition
The replacement property is also parked if the Exchangor needs to renovate. The property is always at the disposal of the Exchangor.
Funding
The Exchangor should have enough funds to secure the replacement property. The EAT stays in a position to receive the Exchangor’s loan from commercial lenders. You should have information on the few lenders that make such accommodations.
Park Relinquished Property
An LLC holds the relinquished property until a buyer is available. After finding a buyer, the single-asset LLC transfers the relinquished property to the buyer. The proceeds from the sale go directly to the holding LLC.
The reverse 1031 exchange is complete after paying off the LLC’s incurred debts.
Park Replacement Property
The Exchangor lends money to the single-asset LLC to secure title to the property. The LLC owns the replacement property until a buyer is available for the relinquished property.
The proceeds cater to the LLC’s initial loan expense. The LLC transfers ownership to the Exchangor to seal the deal.
Rules of Reverse 1031 Exchanges
- They have a time frame of 180 calendar days of the first closing
- The buying and selling taxpayer must be the same party
- The taxpayer’s main residence can’t be the relinquished or replacement property
- The relinquished property must be similar or cost less than the replacement property. The greater the difference, the higher the tax fee
- Only the associated parties should complete the reverse exchange. Disqualified persons aren’t allowed
Why You Should Consider Using a Reverse 1031 Exchange
Investors and individuals find themselves in a position of selling or acquiring property through a reverse exchange. There are various reasons for a reverse 1031 exchange;
- You want to avoid the pressure and risks associated with reverse exchange deadlines. It’s less risky to secure similar or better replacement property using a reverse 1031 exchange process
- You may find a viable opportunity to invest in, and you need to close on it. A reverse exchange allows you to buy into such investments without the need to relinquish your property
You must carry on with the acquisition to complete the reverse exchange deal. Otherwise, you risk losing the replacement property due to a botched sale of the relinquished property.
Corporate investors always organize all their properties as reverse exchanges. They then decide whether to include the sale and matching of the relinquished properties in the reverse 1031 exchange. Reverse 1031 exchanges are more flexible instruments for investment.
Before securing the replacement property, you get 45 days to decide on the property you will relinquish. You also get 135 days to finalize and close on the reverse exchange deal. The total of 180 days significantly reduces the risks.
You only have the prescribed reverse exchange time frame after acquiring and parking. You can park with certified Exchange Accommodation Titleholders.
The Potential Costs of a Reverse 1031 Exchange
A reverse exchange is relatively complicated and time-consuming. There are a few things that make such transactions costly.
The EAT going on title hikes the fee payable for a reverse exchange. While the implied risk on the EAT is reduced, the risk is inherent with owning property. The law also requires the EAT to file tax returns during the parking period.
The reverse exchange process involves multiple parties. The parties are required during the negotiations and transaction. The other parties include banks and insurance companies.
Reverse 1031 exchanges have three closings — two for the relinquished and replacement property. The third closing is for the EAT to release the title for the properties.
The double closing costs include escrow fees, transfer taxes, and insurance. Other prices include legal fees, loans, and tax advisors.
The Case of Unsuccessful Reverse Exchanges
If the investor doesn’t sell the relinquished property within 180 days, they can’t trade in the replacement property. The EAT releases the parked property to the investor. The fee paid for the reverse exchange is non-refundable.
Sometimes it’s challenging to plan and coordinate a 1031 exchange with current market conditions. It requires you to move fast to benefit from existing investment opportunities.
A failed reverse exchange is an opportunity to do a deferred transaction. You should consult your real estate agent for more about a 1031 exchange.
Wrap-up
You should opt for a reverse 1031 exchange under the advisement of a tax advisor. Investors use reverse exchanges to defer taxes on their value-added property. You should find an intermediary to set up the process as early as possible if you’re considering a reverse transfer.
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