How Does a Reverse 1031 Exchange in Real Estate Work?

A reverse 1031 exchange is a way for real estate investors to trade one investment property for another without incurring capital gains taxes. In a 1031 exchange, a taxpayer sells an investment property and purchases a new property with the proceeds from their property sale. In a reverse 1031 exchange, the process is reversed. The investor buys a new property first and then has 180 days to sell their old property which should be of equal or lesser value to the new property.

Reverse 1031 exchanges must be made with like-kind properties that are recognized by the IRS as eligible for tax deferral. Real estate investors trading investment properties in a reverse 1031 exchange must use a qualified intermediary to transfer funds from the relinquished property to the new property. They also need to enlist an exchange accommodation titleholder (EAT) to hold the title of the replacement property for the duration of the exchange period. This agreement is called a qualified exchange accommodation arrangement.

Just like a regular 1031 exchange, the reverse 1031 exchange is only available to those trading investment properties. This does not include a primary residence but can involve rental properties, vacation homes, apartment buildings, and business properties. Other than that, there are a few rules that a property investor must follow when making a 1031 exchange.

• Property value: The value of the new property must be of equal or greater value than the relinquished property. If the new property is of lesser market value, taxes will be imposed on the remaining income from the relinquished property sale.
• Use of funds: The property owner must use all of the money they received from selling their relinquished property towards the purchase of the new exchange property.
• Property type: Both the relinquished property and the replacement property must be considered like-kind properties. For example, residential properties can only be exchanged for other residential properties, making it a like-kind exchange.
• Timeline: The potential relinquished investment property must be identified within 45 days of the purchase of the new property. The relinquished property must then be sold within 180 days of the new property purchase.

A reverse 1031 exchange can allow an investor to move on an enticing property quickly, and puts the emphasis on selling a current investment property rather than finding a new one. Once the investor has identified the new property they want to buy, this is how the reverse 1031 tax-deferred exchange process works.

1. 1. The investor identifies an EAT. The investor must choose an exchange accommodation titleholder (EAT) who will agree to hold the title of the replacement property for the duration of the exchange process. The investor and the EAT enter into a Qualified Exchange Accommodation Agreement (QEAA) together, which is a formal agreement outlining the terms of the exchange.
2. 2. The investor buys the replacement property. Next, the investor must purchase the investment property that will replace their relinquished property. The replacement property must be of equal or greater value to the property they will relinquish. They may purchase the property using cash or finance a loan through a mortgage lender.
3. 3. EAT takes possession of the new property title. Once you've made your QEAA and you've closed on the purchase of the replacement property, the EAT will take over the legal title for the replacement property.
4. 4. The investor chooses their property (or properties) to sell. Within 45 days of closing on the replacement property, the investor must identify which of their existing investment properties they plan to sell. The investor can sell up to three properties, as long as they are of equal or lesser value than the replacement property.
5. 5. The investor chooses a qualified intermediary. The investor chooses who will act as their qualified intermediary and establish a contract with them. The QI will have the right to transfer the title of the relinquished property to the new buyer. They will also transfer the title of the replacement property from the EAT to the investor.
6. 6. The investor enters a contract with the relinquished property buyer. Once the investor finds a buyer for their property, they will enter into a contract with them for the sale of it. The investor should list their EAT as the seller of the property because they are the current title holder for tax purposes.
7. 7. The relinquished property sells. Within 180 days of the purchase of the replacement property, the investor closes on the sale of their relinquished property. The EAT transfers the title of the new property to the investor. If this process occurs within 180 days, they are eligible for tax-deferral on the sales income of the relinquished property.

All investments, including real estate investments, come with inherent risks which may involve the depreciation of assets, financial losses, or legal ramifications. The information presented in this article is for educational, informational, and referential purposes only. Consult a licensed real estate or financial professional before making any legal or financial commitments.

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