1031 Reverse Tax deferred Questions

10 Replies

So here is my situation. I am in contract on a 3 family home for $815k which I will be getting a loan and will be required to put down 25%($204k). Now I have another property(2 family) that was own for about 30 years and can easily get $650k for it. Since I will be purchasing the new property first and than selling the old property within the 6 month period. So my question is since I will be putting the down payment of $203k for the loan but than selling my other property for $650, what happens with the difference? Thanks

First you need to find a Qualified Intermediary, to handle the purchase correctly, for a Reverse 1031.  Any cash from the sale, not reinvested is taxable.

Can't tag Bill Exeter.

Hi Ciro,

It's actually a little more complicated than that. A 1031 exchange by statutory definition is the sale or relinquishment of a property followed by the replacement by the new property. You absolutely cannot take title to your new property before you sell your old property. There is no 6 month period during which you can sell your old property after you have purchased your new property. You are thinking of the 180 days that you have to complete the purchase of your new property from the day that you close on your sale. But you still have to sell your property first. What you are referring to is a "reverse exchange". A reverse exchange can be a wonderful though relatively expensive and somewhat more complicated animal to complete successfully. But it can be invaluable in situations like yours where you've found your perfect replacement property but haven't sold your old property yet.

It's a bit of a misnomer because you will still sell your old property before taking title to your new property. That cannot change. However the reverse exchange can allow you to gain control of your new property before selling your old property. In a reverse exchange your qualified intermediary will form a holding company, usually an LLC, that takes title to the new property on your behalf. This holding company is referred to as the Exchange Accommodating Title Holder (EAT). You are not a member of the LLC nor do you have any ownership in the new property. You do secure the loan and provide the down payment which is made non-recourse to the holding company.

Your interests are protected through recorded mortgages, options to purchase for the same price as the LLC purchased the property and a triple net lease for the amount of the mortgage which provides the holding company a way to pay the mortgage and which gives you full control and use of the property. So you have control but no deeded ownership of the property.

Now you may sell your old property and complete a 1031 exchange buying a new piece of property. And what will you buy??? LOOK - there's a wonderful property owned by an LLC that you already have an option on. Your proceeds from the sale buy the property from the LLC which uses them to pay off the mortgage to the bank and you have completed your reverse exchange. If the new property is more expensive then the bank transfers the remainder of the loan to you or in many cases depending on state transfer tax issues etc we will simply sell the LLC that owns the property to you rather than the property since the LLC, being a single entity single asset LLC, is a disregarded entity for tax purposes.

Think of a 1031 exchange as always sell followed by buy. in a reverse exchange you're still doing that. You're just buying from an entity that is holding the new property in trust for you.

Another place the 6 month window you were talking about crops up is in the type of reverse exchange your undertake. The IRS issued a safe harbor for reverse exchanges in rev procedure 2000 - 37. Two of the safe harbor criteria are that within 45 days from the day you start the reverse portion of the exchange you submit a list of the properties you will be selling. And secondly that you must complete the sale of your old property and the purchase from the Exchange Accommodating Title Holder within 180 days from starting the reverse portion. Yes it sounds similar to a straight exchange but remember that in the straight exchange your 45 and 180 days start at the sale of the old property. In a reverse exchange they start at the purchase of your new property from the EAT.

There are also structures that allow reverse exchanges to exist outside the safe harbor but like everything they can be more complicated and costly. This is also requires a special lender usually a local portfolio bank or private commercial bank or individual who understands 1031 exchanges.

So, sorry to say you've got a few more steps to go through to shelter the tax on that 2 family but having owned it for 30 years I can imagine it would be worth it.

Good luck

Great post by @Dave Foster  .  I would add that there are some additional expenses that will pop up, one of which will be an extra transfer payment because the replacement property changes ownership twice; in PA we have the highest transfer taxes in the USA so it's something we know to pay attention to. 

Maybe @Bill Exeter  has something to add. 

Updated about 3 years ago

The words "transfer payment" should read "transfer tax payment"

Thanks @Steve Babiak,  Transfer taxes can be a bear!  That and liability protection are usually the two biggest reasons we transfer the single entity LLC to the client rather than the property at the end where allowed.  States though seem to be recognizing more and more the structure of the 1031 process and offer exemptions for transfers just like this in a reverse exchange.  Whether through state exemption or transfer of the disregarded LLC it would be worth looking into eliminating those pesky transfer taxes. 

In PA they would get a transfer tax on the transfer of the LLC. Plus the state of PA does not recognize 1031 exchange tax deferral, so the tax on the gains of the relinquished property is due to the state in the year of sale.

Updated about 3 years ago

The words "transfer payment" should read "transfer tax payment"

Updated about 3 years ago

The update on this post was placed on the wrong post, so ignore it here

Yah every state can have their own nuances which makes your personal cpa so critical in the process. But there's hope for you.  PA has been full of political rumblings of 1031 recognition for a couple of years.  The new administration might throw a wrench in that.  What's your read on the ground @Steve Babiak  ?

@Dave Foster  - political discussion is supposed to be confined to the off topic area, so I will just comment that the new administration in PA seems to want to tax more, so transfer taxes aren't going away, and tax deferral via 1031 is unlikely to be recognized. 

Originally posted by @Dave Foster :

Thanks @Steve Babiak,  Transfer taxes can be a bear!  That and liability protection are usually the two biggest reasons we transfer the single entity LLC to the client rather than the property at the end where allowed.  States though seem to be recognizing more and more the structure of the 1031 process and offer exemptions for transfers just like this in a reverse exchange.  Whether through state exemption or transfer of the disregarded LLC it would be worth looking into eliminating those pesky transfer taxes. 

States such as Pennsylvania, New York, New Jersey and others do not offer any exemptions for the second transfer. The states will assess a double documentary transfer tax even with the transfer of the LLC. We have tried arguing with NY, NJ and PA numerous times and they will not budge.

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