Capital gains taxes can cut into a real estate investor’s profits. Depending on your income, you can pay up to 20% if you sell an investment property. A reverse 1031 exchange lets you avoid those taxes.
What is a reverse 1031 exchange?
A reverse 1031 exchange is based on Section 1031 of the Internal Revenue Code. Under Section 1031, the Internal Revenue Service (IRS) doesn’t recognize a gain or loss If you exchange one business or property investment for another. The income from the sold property goes toward the cost of the new one, so it doesn’t count as income.
A reverse 1031 exchange is “backward” because you buy the new property before selling the one you’ll be letting go of. The IRS still counts the sale’s funds as part of the exchange, as long as the transaction and time frame are within limits.
1031 reverse exchange: How to qualify
Any investment or business property owner can qualify for a reverse 1031 exchange. You can qualify as an individual, a partnership, a limited liability company (LLC) or a C or S corporation. Trusts and other taxpaying entities also qualify, as long as they already hold investment property.
The property must also meet the following requirements:
- Property use limitations: You can only do a reverse 1031 exchange on a property you hold and use for commercial purposes. Corporate assets and rental properties both count. Personal-use properties like vacation homes don’t, even if you rent them out occasionally.
- Like-kind status: The properties must be in the same property category. Most real estate in the US is like-kind to other real estate, even if the buildings aren’t similar. A mixed-use office building can be like-kind to an apartment building. It can’t be like-kind to artwork, precious metals or real property outside of the US.
- Acquisition requirements: You can purchase no more than three properties with the funds from your sold property. If you plan to identify more than three, consult an attorney. It may be allowed, but there are special rules involved.
If you have any questions about whether your exchange qualifies, consult an attorney. The IRS is exacting, and mistakes can be costly.
Reverse 1031 exchange timeline
A reverse 1031 exchange needs to happen in a certain order and time frame. Here’s how it works.
Step 1: Create a Qualified Exchange Accommodation Agreement
To qualify for deferred taxes on a reverse 1031 exchange, you can’t own both properties at the same time. You avoid this by naming someone as your exchange accommodation titleholder (EAT).
“The EAT maintains title to the property being exchanged until the transaction is complete and then assigns it to the buyer,” said Shaun Martin, CEO of We Buy Houses in Denver. “After that, the EAT hands over ownership of the property to the buyer.”
Your EAT will identify themselves as part of a Qualified Exchange Accommodation Agreement (QEAA). This document names your EAT as the person who will hold the purchased property for you. It also states that the EAT will return the title to you when the process is complete.
You’ll also need to choose a qualified intermediary (QI). This person handles the exchange documentation, including title transfers.
Step 2: Purchase the replacement property
The EAT will officially buy the new property. You provide the funds in cash or via a loan in the EAT’s name. The EAT will legally own the new property until you’ve sold the relinquished property.
Step 3: Identify a new property to sell
Once you’ve closed on the replacement property, you have 45 days to officially identify the property you plan to sell in exchange.
You can sell multiple properties. If your income from the sale exceeds the new property’s cost, you’ll owe taxes on the difference. Investors who plan to buy and sell multiple properties may wish to set up multiple exchanges.
Step 4. Sell the relinquished property
Once you’ve transferred the title of your new property to your EAT, you have 180 days to transfer it back. Before that happens, you need to close on the relinquished property. Find out how long closing takes in your market and leave plenty of time.
Step 5: Reclaim the title on your purchased property
Your QI will help you facilitate the transfer of your new property’s title from your EAT back to you as the investor.
1031 exchange vs. reverse 1031 exchange
A reverse 1031 exchange works similarly to a standard 1031, but they serve different purposes.
In a standard 1031 exchange, also known as a deferred exchange, the investor sells an investment property and uses the proceeds to buy a new property. In a reverse exchange, the investor buys the new property before selling the replaced property.
“Normally, when I sell an investment property, it is subject to these capital gains taxes,” said Tomas Satas, founder and CEO of Windy City HomeBuyer. He is a real estate investor and landlord in Chicago who does standard and reverse 1031 exchanges to avoid capital gains tax and taxable income from property sales. “But in a normal 1031 exchange, I would use those funds to purchase another investment property of equal or greater value, and avoid the taxes since that money is an expense, not revenue.”
“In a reverse 1031 exchange, I purchase a new investment property and have 180 days to sell the previous property to qualify for the tax break,” he said. “This makes the best sense in a situation where I have to act fast to obtain the property.“
Cost of 1031 reverse exchange
A reverse 1031 exchange typically costs between $3,000 and $5,000.“The actual cost will depend on the complexity of the transaction and the number of properties involved in the exchange,” Martin said.“If the transaction is complex, it will take longer to complete and require more experienced professionals’ services. This will increase the cost of the exchange.”
The people involved will depend on how complex the property is and how many properties are involved. Make sure you have enough funds to pay your EAT and QI, and your real estate agents and appraisers.
1031 reverse exchange pros and cons
A reverse 1031 exchange can help you enhance your portfolio, but there are drawbacks. Here’s what to know before you commit.
Flexibility to act quickly
A standard 1031 exchange requires you to sell your relinquished property before buying. With a reverse exchange, you can buy first and sell later. This lets you act fast in a hot market.
More time to buy
In a standard 1031 exchange, you have to buy a replacement property within 45 days of selling your relinquished property. A reverse exchange allows more time to find a replacement property.
Higher out-of-pocket cost
You buy before you sell in a reverse 1031 exchange. Your equity is still tied up in the property you plan to relinquish, so you’re on the hook for the purchase price.
If you don’t have the cash, you can take out a line of credit or mortgage the purchased property. A mortgage must be in the EAT’s name, which can complicate matters. Consult an attorney before starting this process.
More risk of incurred taxes
“A reverse 1031 exchange is a complex transaction,” said Martin. “There are strict deadlines to meet to qualify for the exchange. If any of the deadlines are not met, the transaction will not qualify.”
If the transaction isn’t valid, you’ll have to pay capital gains taxes on the sale of your investment property.
Getting started with a reverse 1031 exchange
A reverse 1031 exchange is a helpful tool to expand or diversify your portfolio, but it’s a complex process with specific legal requirements. If you’re considering making this kind of exchange, start by consulting with an attorney or real estate investment advisor.
Frequently Asked Questions
What happens if a reverse 1031 falls through?
If a reverse 1031 exchange falls through—for example, if your buyer backs out and you can’t find another within the required time frame—it’s no longer an exchange. You can still choose to sell the replacement property or another property you own. However, you will owe those taxes unless you find a qualified replacement property within 180 days from the purchase of the new investment property.