What Is a Reverse 1031 Exchange?

Being tax-smart about real estate is essential to making investments as profitable as possible.

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Investing in real estate can open the door to some amazing and profitable opportunities. To make the most of real estate investing, however, it's critical to know the ins and outs of real estate taxes.

One of the biggest advantages that real estate investing has over other types of assets is that you can often exchange one property for another without having to pay taxes on any increase in the value of your property.

These transactions are known as 1031 exchanges. Even though 1031 exchanges can be simple, investors sometimes have to do things a little differently. That's where a reverse 1031 exchange can be handy. But before getting into reverse 1031 exchanges, let's look more closely at how regular 1031 exchanges work.

The basics of the regular 1031 exchange

Section 1031 of the Internal Revenue Code says that no gain or loss is recognized on an exchange of one piece of real property for another property of like kind. 1031 exchanges are limited to property used in a business or for investment, so it's not available for a home or other property that's not held for productive use.

As an example, say that you bought a rental property as an investment 10 years ago for $200,000 and it's now worth $300,000. You decide you'd like to move to another area and you prefer to have your rental nearby. You find a similar property in the new location that's also worth $300,000. If you exchange your old property for the new one, you won't have to pay capital gains taxes on the $100,000 appreciation in your old property.

The problem with this simple form of 1031 exchange is that it's rare to find someone who's interested in a direct swap for your property. However, if you follow a more complex set of rules, the tax law lets you do an exchange in several steps:

  • First, you find an institution or individual known as a qualified intermediary (QI). The QI holds the proceeds from your real estate sale.
  • Then you need to identify the replacement property and have the qualified intermediary use the proceeds to buy it within a set period of time. You have 45 days after the sale of the old property to identify a replacement property and 180 days after the sale to close on the exchange.

This method makes 1031 exchanges far easier. You can sell your property to someone unrelated to the person whose property you want to buy and still get favorable tax treatment. This dramatically expands the range of potential buyers, sellers, and replacement properties.

However, there's still a shortcoming of the regular 1031 exchange: You have to wait until your old property sells before you can move forward and buy a replacement property. If your property takes a long time to sell, you might miss out on investment opportunities.

That's where a reverse 1031 exchange can be useful. It lets you flip the timeline in certain circumstances.

How a reverse 1031 exchange works

With a reverse 1031 exchange, the order of the transactions gets reversed. Here's how it works:

  • First, you look at properties you want to buy to replace your old property and find a QI to work with you on the exchange.
  • Then you move forward with the sale of your existing property. Again, you'll have 45 days from the date of purchase to identify the property you're going to sell and 180 days to close on the exchange.

Qualified intermediaries offer a couple of ways to structure reverse 1031 exchanges. Under one method, you purchase the replacement property yourself and then transfer title of your old property to the QI.

Under the other, the qualified intermediary purchases the replacement property using financing that you provide and then turns over title to you once your old property sells.

Pros and cons of reverse 1031 exchanges

The most obvious advantage of reverse 1031 exchanges is that you don't have to wait until your existing property sells before choosing and acquiring a replacement property. That's especially important if there's a lot of demand for the property you're interested in buying. You could lose out on the opportunity if you have to wait for your existing real estate to sell.

Reverse 1031 exchanges create some challenges, however. If you can't sell your existing property within the 180-day timeframe, you'll lose favorable tax treatment and have to pay taxes on the gain.

In addition, you have to come up with money to purchase the replacement property before you have the proceeds from the sale of the existing property. It can take extra effort to convince a lender to provide financing in these situations.

Some other things to keep in mind

Many of the rules governing regular 1031 exchanges also apply to reverse 1031 exchanges. That includes the following:

  • Most properties count as like-kind for Section 1031 purposes even if they don't seem to be of the same type. For instance, you can do an exchange of a commercial building for an apartment complex or undeveloped land for a developed property. However, you can't exchange U.S. property for foreign real estate and get favorable tax treatment.
  • If the replacement property costs less than the proceeds from the sale of the old property and you receive cash for the difference, that cash is subject to tax. Consider the example above with a property that went from $200,000 to $300,000 in value. If you exchange it for a replacement property worth $275,000 and take $25,000 in cash to make up the difference, you'll pay tax on the $25,000. The remaining $75,000 in capital gains would still be tax-deferred.
  • If you have a loan on your old property, you have to make sure your loan on the replacement property is at least as large. Otherwise, the reduction in the outstanding loan amount after the exchange will be taxed the same way as if you had gotten cash out of the deal.

If you have a property that's gone up in price and want to trade it for another property you've found, a reverse 1031 exchange can let you move quickly to lock in that replacement property while still giving you the tax benefits of long-term deferral.

As long as you're confident that you can close on a sale of your current property within 180 days, the reverse 1031 exchange can be a great way to make a shift in your overall real estate investment strategy.

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