Reverse 1031 Exchange: What It Is & How It Works

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To understand a reverse 1031 exchange, you should first make sure you know the ins and outs of a 1031 exchange. Key differences exist between a standard 1031 exchange and a reverse 1031 exchange, designed to defer taxes while investing in real estate.

Read on to learn more about what it is (and how it differs from a 1031 exchange), how to complete one, and how it can benefit you.

What Is a Reverse 1031 Exchange?

A reverse 1031 exchange is a tax deferment strategy that allows real estate investors to purchase a second investment property before selling their relinquished investment property—and, importantly, defer capital gains taxes and other taxes that you would normally need to pay at the sale of a property. Because a reverse 1031 exchange is more complicated than a standard 1031 exchange, it’s important to understand it fully before proceeding.

In a reverse 1031 exchange, the investor, also referred to as the taxpayer, first purchases property before selling the relinquished property (as opposed to a standard 1031 exchange, where the order of operations is reversed).

After purchasing the replacement property, the investor has 45 days to designate up to three properties to sell. You then have 135 days within the exchange period to get under contract and close the relinquished property sale. Reverse 1031 exchanges are executed under the IRS’s safe harbor guidance of Revenue Procedure 2000-37, which states that you have a total of 180 days from the purchase of the new property to complete the full transaction.

That may seem straightforward enough, but there are some additional hoops to jump through. You cannot hold the title of the replacement property yourself upon purchase. An Exchange Accommodation Titleholder (EAT) must hold on to or park the title throughout the 1031 exchange period for tax purposes.

You must also retain the services of a Qualified Intermediary. Only when the relinquished property is sold can the Qualified Intermediary transfer the title of the relinquished property to the new buyer and the replacement property to you, the real estate investor.

Related: 4 Rules of 1031 Exchanges Every Investor Should Know

How Does a Reverse 1031 Exchange Work?

A 1031 reverse exchange can be a complicated process, but with the following timeline, you can see the steps to take as a property owner. If you have any questions, speak with your investment advisor, a Qualified Intermediary, or EAT about the specifics of your situation.

Find a replacement property

Inform the title company that this is a reverse 1031 exchange property, and ensure the contract allows you to transfer the title to the EAT of your choice. The replacement property must be of equal or greater value to the property you plan to sell.

During this step, be sure you have appropriate financing or proof of adequate cash to purchase the property. This may include conventional loans, short-term financing, or purchasing the property in cash.

Timeline: Month 1 

Enter a qualified exchange accommodation arrangement

The Qualified Exchange Accommodation Agreement is a legal contract between you and the EAT, stating the terms regarding holding title to your replacement property until you relinquish the property and sell it.

Timeline: Month 1

EAT acquires the title

After obtaining mortgage financing, the EAT will acquire the title of your replacement property, parking it until the relinquished property sells.

Your EAT takes possession of the property until you complete the sale of your relinquished property.

Timeline: Month 1

Designate the property to be relinquished

Within 45 days of EAT acquiring the title of your replacement property, you must identify up to three properties as potential relinquished properties.

*You can also lease the parked property from the EAT, allowing you to control the property before you complete the reverse 1031 exchange.

Timeline: Month 2-3 (varies depending on response time)

Locate a buyer and close the sale

You must find a buyer, enter an executed purchase contract, and close the sale within 135 days of identifying your relinquished property. 

The contract should name the EAT as the seller of the property. Like any sale, the contract should include all details of the sale and be ready to close within the 180-day timeline. 

Timeline: Month 2-6 (varies depending on response time)

Create an agreement with your qualified intermediary

Your Qualified Intermediary is responsible for transferring the relinquished property title to the buyers and taking possession of the title of your replacement property with the EAT.

The agreement should state the transfer details, including the rights for the buyer to take possession of the title after closing.

Timeline: Month 2-6 (varies depending on response time)

Transfer the deed to the relinquished property

The Qualified Intermediary will oversee the deed transfer for the relinquished property to the new buyer. The QI will also receive the funds from the buyer, using the funds to obtain the parked property from your EAT. Some of the funds may also cover closing costs.

Timeline: Month 2-6 (varies depending on response time)

Obtain your deed

When all money has exchanged hands and the buyer has the deed to the relinquished property, you can receive the deed for the parked replacement property. 

The QI oversees the entire process to ensure the relinquished property transfers properly and that you have complete possession of the replacement property upon completion within 135 days (180 days total).

Timeline: Month 2-6 (varies depending on response time)

Related: How a 1031 Exchange Can Make You Millions

The Difference Between a 1031 Exchange and a Reverse 1031 Exchange

The largest difference between a 1031 exchange and a reverse 1031 exchange is the order in which you buy and sell investment properties. In a standard 1031 exchange, you sell the property first and then replace it with another new property. You must do this within 180 days of closing on the sold property, so the exchange period is similar between the two processes.

A reverse 1031 exchange is the opposite. You purchase the replacement property first and then have 45 days to choose a property to sell and 135 days to relinquish property and complete the process. This works best when an investor finds a property at the perfect price and with the ideal features before listing an existing home for sale. Then, they can capitalize on the opportunity and still take advantage of the 1031 exchange benefits.

When you find a replacement property first, you must put the property into a qualified exchange accommodation agreement, essentially giving possession of the home to your Exchange Accommodation Titleholder (EAT) until you satisfy the terms of the agreement, selling your relinquished property within 180 days from the start of the process.

Types of Reverse 1031 Exchanges

There are two variations of reverse 1031 exchanges, and they both have benefits and disadvantages.

Exchange last

In an exchange last reverse 1031 exchange, the EAT acquires the replacement property and holds/parks it until you sell the relinquished property. This is one of the most common types of reverse 1031 exchange transactions.

This type of exchange is preferred because it gives you more flexibility, but it can cause problems with your lender if they are concerned about the EAT holding the replacement property title. It is important to speak to different lenders to discover their stance on this reverse 1031 exchange structure.

Exchange first

In an exchange first reverse 1031 exchange, you acquire your replacement property first, your lender lends directly to you, and simultaneously you hand the title over to the EAT.

While this will work for most lenders, you need to reinvest the total amount of equity in your relinquished property into your replacement property before the former sale closes; having this kind of cash on hand is rare.

Benefits of a Reverse 1031 Exchange

There’s no argument that a reverse 1031 exchange is more complicated than a straightforward, standard 1031. So why would an investor choose to go this route? There are a few reasons:

• To secure a property: If you’re in a competitive market, you may want to secure the replacement property you have your eye on before someone else grabs it.
• To ensure you have a replacement property: If you have the means to purchase the replacement property first, that eliminates the risk of finding a replacement property in just 45 days, as is the course of action in a 1031 exchange.
• To minimize tax liability risk: If you don’t sell the relinquished property within 180 days, you shouldn’t have any tax liability, says registered investment advisors CWS Capital Partners. However, you would have a tax liability if you choose to do a standard 1031 exchange and sell the relinquished property but can’t close on a replacement property.

Risks and Considerations of a Reverse 1031 Exchange

While there are certainly benefits to a reverse 1031 exchange, there is also some risk in the exchange transactions. Here are some of them.

You may need to have liquid assets on hand

It may not worry you if you have liquid assets to purchase the replacement property before selling the relinquished property. However, you must get a loan for the replacement property if you don’t. That itself can lead to risk.

The lender doesn’t approve the loan for your replacement property

Some lenders will not participate in an exchange in which an EAT will hold the title. It’s best to find this out before you begin the process.

You can’t sell the relinquished property

If your property is in a slow market or there is little interest, you may be unable to enter into a contract and close the sale within 135 days from designation. If this is the case, the exchange will fail.

If you need to make improvements, you need to start right away

If you already know which property you will designate as the relinquished property and that property needs physical improvements via construction, you need to start right away. There are commonly delays in construction work, and if the work goes past the 180th day, the construction manager will apply the percentage complete to your tax deferral.

As with any big real estate investment decision, it’s crucial to plan out every step of your reverse 1031 exchange before you start due to the many steps and considerations involved.

Reverse 1031 Exchange FAQs

What are the costs of a reverse 1031 exchange?

There are several costs to be aware of when performing a reverse 1031 exchange. The EAT must report its ownership of the replacement property to the IRS, which will incur transaction costs. These costs include transfer fees, mortgage taxes, recording fees, lender charges, escrow and title fees, and legal fees. Additionally, you must pay an accommodation fee, which will vary based on the provider, the size and complexity of the exchange, and any other issues involved.

You can expect to pay around $3,500, but it’s best to speak with a Qualified Intermediary about your specific situation to get an exact number.

How much time do you have to do a reverse 1031 exchange?

You have 180 days to complete the reverse 1031 exchange. First, you purchase the property you want, and then choose a property to sell. After purchasing a property, you can name up to three properties to sell, but it must be within 45 days. After the 45 days, you must contract and close the sale within 135 days, for a total of 180 days.

Can you undo a 1031 exchange?

If you decide after purchasing a property and naming up to three properties to sell to defer the capital gains taxes to change your mind, you can. You aren’t obligated to follow through; however, you are responsible for paying the applicable taxes on the capital gains.

Final Thoughts

A reverse 1031 exchange is a good option for investors who find a property they can’t pass up before they’ve sold an existing property. This tax deferment strategy lets you play with your real estate investments without incurring large tax liabilities. However, the nuances of the reverse 1031 exchange are slightly different from a traditional 1031 exchange, so be sure you understand the differences before moving forward.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.