The Big Picture On The Reverse 1031 Exchange Timeline & Rules:
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- Unlike a traditional 1031 exchange, where you sell a property first, a reverse 1031 exchange allows you to buy the replacement property before selling the relinquished one.
- To comply with IRS rules, investors must declare the property they plan to sell within 45 days of buying the new property and close the sale of the relinquished property within 180 days.
- Securing financing is challenging because lenders may hesitate to work with reverse 1031 exchanges, as the EAT initially holds the title to the new property.
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Real estate investors can famously defer capital gains taxes on investment properties with a 1031 exchange. They sell a property for a profit and roll the proceeds into a new real estate investment to avoid paying capital gains on the sold property—at least for the moment.
But did you know that you can do a 1031 exchange in reverse?
Keep the following rules and timelines in mind as you explore doing a reverse 1031 exchange.
What Is a Reverse 1031 Exchange?
You first sell an investment property in a traditional 1031 exchange — also known as a delayed 1031 exchange. You then buy a like-kind property with the proceeds within 180 days of selling the prior property.
This lets you roll over those proceeds into the replacement property without paying capital gains taxes or depreciation recapture on the swapped investment properties. But you’ll still owe both on the new property when you sell it.
Unless you 1031 exchange that property into a new one, of course.
“Yeah, yeah, I know how a normal 1031 exchange works. What about reverse 1031 exchanges?”
In a reverse 1031 exchange, you buy the replacement property before selling the current property. For a little while, you own both properties.
That means you need enough money to buy the new property without having sold the relinquished property yet. And since the IRS makes the rules for 1031 reverse exchanges, you can expect all kinds of nitpicking and complications.
Important Points of 1031 Exchange
For a clearer picture, here are some of the most crucial points about the 1031 exchange.
Aspect | Details |
Time Limit | Must sell the relinquished property within 180 days of acquiring the replacement property. |
Qualified Intermediary | Required to facilitate the exchange and hold title to the replacement property. |
Parking Arrangement | The replacement property is “parked” with an Exchange Accommodation Titleholder (EAT). |
Financing Challenges | Additional financing or cash reserves may be required to purchase the replacement property first. |
Identification Period | Still applies; must identify the property to be relinquished within 45 days of acquiring the replacement property |
Risk | There is a higher risk if the relinquished property cannot be sold within the time limit. |
Use Cases | Useful in competitive markets or when a unique opportunity arises that can’t wait for a traditional exchange. |
Why Do a 1031 Reverse Exchange?
As a real estate investor, you don’t always know when the next deal will come along. After all, you can’t just order a rental property online whenever you feel like it. (Actually, you can on Roofstock, but that’s another story.)
The point is that sometimes great deals on real estate come along when we least expect them. In a competitive market, it’s often hard to find good deals. So, the tax code lets you buy the new replacement property before you sell the old property if that’s more convenient for you.
It also removes the deadline for settling on the new property. If delays strike while purchasing the new property, it simply pushes back your deadline for selling the relinquished property.
You can buy and sell the two properties at your own speed, at least within the 180-day window allowed you.
Reverse 1031 Exchange Timeline
In a classic 1031 exchange, you have 45 days after selling the old property to declare the new one. The IRS does let you name three possible properties since sales contracts can and do fall through.
To remain in compliance, you must close on the new replacement property 180 days after the old property’s settlement date.
The same timeline applies to reverse 1031 exchanges, except backward. Within 45 days of buying the new property, you have to declare which property you’re selling. And you have to settle the sale within 180 calendar days of closing on your new property.
Steps of a 1031 Reverse Exchange: Simplified
While the concept and timelines are simple, the reverse 1031 exchange process and steps get trickier, but I’ll simplify them as much as possible.
The steps include:
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- Choosing Your New Property: Find the property you want to buy and make sure you have the money to purchase it.
- Setting Up Your Team:
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- Hire a Qualified Intermediary (QI)
- Create an Exchange Accommodation Titleholder (EAT)
- The EAT is usually a new LLC set up to hold your new property temporarily
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- Buying the New Property: Close the deal on your new property. The EAT will hold the title for now.
- Identifying Your Old Property: Officially declare which property you will sell within 45 days of buying the new property.
- Finding a Buyer: Get a contract to sell your old property. Remember, the EAT is technically the seller, not you.
- Doing The Paperwork:
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- Allow your QI to handle the sale of your old property
- Arrange for the new property to be transferred from the EAT to you
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- Selling Your Old Property: Complete the sale within 180 days of buying the new property. The money from this sale goes to your QI.
- Finalizing the Exchange: Your QI uses the money from the old property to “buy” the new property from the EAT. Then, the new property is transferred to you.
Exchange First vs. Exchange Last
Adding to the complications is choosing between an “exchange first” reverse 1031 exchange or structuring it as an “exchange last.”
In an “exchange first” reverse 1031 exchange, you sell the old property to the Exchange Accommodation Titleholder (EAT) for its estimated full-market value as the first step. You provide the money for them to buy it. They then take title to the new replacement property — which you also have to cover financially. Once you find a buyer for the relinquished property and it settles, the EAT reimburses you and the sale proceeds.
In an exchange last deal, you provide the EAT with funds to buy the new property, and they buy it on your behalf. The technical 1031 exchange happens later when they sell the relinquished property.
Whew! Got all that?
The 1031 reverse exchange process involves many middlemen and moving parts. It’s not convenient or cheap.
As we alluded to earlier, they come with far too many fine print rules.
Reverse 1031 Exchange Rules
The first rule of 1031 exchanges is that you can’t touch the proceeds from the sold property. You hassle with a QI and a qualified exchange accommodation arrangement.
In the case of reverse 1031 exchanges, you also can’t own or possess the new replacement property until you sell the old relinquished property. You can’t legally own both properties at the same time.
However, You can improve the new property once the EAT owns it.
As with traditional 1031 exchanges, you can only swap like-kind properties. You also can’t exchange 1031 for your primary residence.
The other safe harbor rules apply to both types of exchanges as well. You must own the real property for at least two years, you must have rented it at fair market value for at least 14 days in each year, and you can’t have used the property yourself for more than 14 days in each year (or 10% of the days you rented it to others).
Lastly, if the new property costs less than the relinquished property, you owe taxes on the difference.
Why Like-Kind Properties Only?
The IRS only allows like-kind properties under IRC Section 103, perhaps also to prevent taxpayers from abusing the system for personal gain.
Commercial real estate typically qualifies as like-kind to other commercial properties. For instance, you can exchange a multi-family apartment complex for a commercial office building without issue. On the other hand, using a primary residence or vacation home as an exchange property introduces significant complications.
To be specific, the properties involved must be “held for productive use in a trade, or for business or investment” purposes, which, in most cases, excludes personal residences.
Commercial buildings can be exchanged for apartment buildings, and office spaces can be swapped for retail properties as long as they’re used for business or investment.
While rare exceptions exist for exchanging personal properties under specific circumstances, dealing with these scenarios requires expert guidance to avoid violating IRS regulations.
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Cost of a 1031 Reverse Exchange
Because intermediary entities have to take title to your properties, it adds considerable cost.
Expect reverse 1031 exchanges to cost between $4,500 – $7,500, not including transfer taxes. That’s significantly more than forward 1031 exchanges.
Some states waive transfer taxes for transfers between you and your EAT, but others don’t. Talk to your QI about the rules in your state.
What Happens If You Can’t Sell Your Old Property In 180 Days?
What if you fail to sell the old property after the 180-day timeframe?
One solution involves terminating the exchange, which means you’ll take ownership of the replacement property and deal with the capital gains taxes when the relinquished property eventually sells
You may also proceed with the reverse exchange outside the safe harbor provisions. Safe harbor time limits, while not mandatory, provide a layer of protection against IRS challenges. Going beyond them carries more risks, such as IRS scrutiny and audits.
Challenges of a Reverse 1031 Exchange
By now, you should already have a sense for all the legal gymnastics required for a reverse 1031 exchange.
Chief among the challenges are the costs, of course. But the hurdles don’t end there.
In a reverse 1031 exchange, you have to come up with the money to buy a new property before selling the old property. That means you need to cough up huge quantities of cash out of pocket to cover the exchange funds.
And while you can borrow a rental property mortgage to buy the new property, don’t expect it to be easy. Remember, the EAT will initially take title to the property, not you. That makes most lenders nervous at best. Many simply won’t work with reverse 1031 exchanges.
In an exchange-first deal, you can buy the property in your own name to appease the lender with an immediate transfer to the EAT. But lenders also expect you to put in every penny you earned from selling the old property — an amount you won’t know since you haven’t sold it yet. That means coughing up even more cash when you close on the new property.
Then there’s the time crunch to sell the original property. Remember, you have 180 days to close on selling the old property. If the property fails to sell, you might have to cut the price below what you planned on getting for it.
Also, beware of contractor delays if your old property needs repairs before selling. Blown repair schedules give you even less time to market and sell the property.
Final Thoughts
If you don’t want a steep bill on your next tax return, 1031 exchanges offer a great tax deferment strategy.
You get to swap out a smaller property for a bigger investment opportunity that will allow cash to flow better. You skip the payment of capital gains taxes or depreciation recapture for now. And 1031 reverse exchanges add flexibility, letting you find a deal and close the replacement property before selling the original property. In a seller’s real estate market where it’s hard to find deals, that makes your life easier.
But these tax-friendly real estate transactions come at a cost. You must pay a princely sum to a qualified intermediary to handle all the paperwork and temporarily hold the replacement property title. It’s a complex transaction, and you typically need to come up with the money for the new property before selling the old one.
When in doubt, talk to an accountant or investment advisor before committing to a reverse 1031 exchange.♦
Still have questions about reverse 1031 exchange timelines? Don’t be shy; ask below!
I should’ve reverse 1031 exchange when I bought out a good deal and sell my old property. The timeline was just right.
Next time Jovan!
Reserve 1031 exchange is pretty handy in certain sitation but quite tricky to pull off since a lot of cash is required.
No question Theodore. Definitely not for all investors or transactions!
Didn’t know you could do 1031 exchanges backwards like this. Another option on the table I suppose
The more tools you have in your real estate investing toolbox, the better!
Seems expensive. Your capital gains tax bill would have to be enormous to make this worthwhile. Thoughts?
I agree, 1031 reverse exchanges make the most sense for high-value properties. Otherwise the juice probably isn’t worth the squeeze.
Could come in handy someday. Thanks for the share
You got it Alfonse!
I never use reverse 1031 exchange in any of my deals but I’ll remember this in case I have a strict time sensitive deals.
I hear you Marie. Always good to have another tool in the toolkit!
What a unique way to protect against tax liability!
Always good to have more options on the table 🙂