Navigating the Reverse 1031 Exchange: Preserve Capital Gains While Securing New Land

A reverse 1031 exchange, also known as a reverse like-kind exchange, allows a property owner to purchase a replacement property before selling their original property while still deferring capital gains taxes. This type of exchange can be particularly useful when a property owner finds an ideal purchase opportunity before they’ve had a chance to sell their existing property. Here’s a step-by-step overview of how it works:

Establishing the Reverse Exchange

The property owner identifies the new property they want to acquire (the “replacement property”). A qualified intermediary (QI), often referred to as an Exchange Accommodator Titleholder (EAT), is engaged to help facilitate the reverse exchange. This intermediary plays a crucial role in holding either the newly acquired property or the existing property temporarily to meet IRS rules.

The Qualified Intermediary Takes Title

In a reverse 1031 exchange, the QI or EAT must hold the title to one of the properties temporarily. There are two structures:

• Exchange Last (EAT holds the replacement property): The QI takes title to the replacement property (the property you want to buy) and holds it until you sell your original property.

• Exchange First (EAT holds the old property): The QI takes title to your original property until it’s sold, and you directly purchase the replacement property.

Identification of the Relinquished Property

After the purchase of the replacement property, the property owner has 45 days to identify which property they plan to sell (the “relinquished property”). The identification must be in writing and submitted to the QI.

Selling the Relinquished Property

The property owner has up to 180 days (including the 45-day identification period) to sell the relinquished property after purchasing the replacement property.  Once the sale is finalized, the QI uses the proceeds from the sale of the original property to transfer the title of the replacement property to the property owner.

Completing the Exchange

When the sale of the relinquished property is complete, the proceeds go through the QI to ensure they are used to offset the cost of the replacement property, which satisfies the requirements for the 1031 exchange. If all criteria are met within the 180-day period, the capital gains tax deferral is preserved.

Key Points to Remember:

• Timing is Critical: The 45-day identification period and the 180-day completion period are non-negotiable. Missing these deadlines could result in a failed exchange and trigger capital gains taxes.

Use of a Qualified Intermediary: A QI is required for the reverse 1031 exchange to ensure compliance with IRS regulations. The property owner cannot take control of the proceeds at any point.

• Financing Considerations: Reverse 1031 exchanges can be more complex than standard ones, especially regarding financing. The property owner may need to secure financing for the purchase of the replacement property without relying on the sale proceeds of the original property initially.

• Costs: Reverse exchanges tend to be more expensive than traditional 1031 exchanges due to the complexity and additional services provided by the QI.

In short, a reverse 1031 allows you to secure your desired replacement property before selling your existing one, thus reducing the risk of missing out on an opportunity. However, it requires careful planning and coordination with a qualified intermediary to ensure that all IRS requirements are met.