I think you’ll agree with me when I say:
An “IRC Section 1031 Reverse Exchange” sounds pretty complicated.
But is it?
As a matter of fact, A Reverse 1031 Exchange is pretty straight forward; It’s just a regular 1031 Exchange, in reverse! And as long as you’re getting advice from an experienced 1031 Exchange Accommodator, they can be even easier than a regular 1031 Exchange.
And in today’s post, I’m going to explain the rules, the timeline, the cost, and more…
…Giving YOU the Ultimate Guide to starting and completing a successful 1031 Reverse Exchange.
We’re going to dive deep into the 1031 Reverse Exchange, but feel free to jump to any section that interests you:
- Timeline (Time Limit)
- Pros and Cons (vs. a Standard 1031 Exchange)
- How to Get Started
But before we get started:
Please note that this article is simply meant to give you an overview of the rules and timelines of a Reverse 1031 Exchange. Before engaging in a Reverse 1031 Exchange, investors should ALWAYS consult with their legal, financial, and tax professionals, as well as an experienced Qualified Intermediary (like 1031 Exchange Advantage ®) before entering into a Reverse 1031 Exchange.
That said, let’s jump right in.
When a piece of real estate is sold, capital gains taxes can take roughly 20-40% of the profit, depending on the state where the property owner (taxpayer) lives.
In states like Texas, or Washington, there are no state capital gains taxes.
However, in states like California, state capital gains taxes can take 13.3% of profit in addition to federal capital gains taxes!
Take a look at the chart below to see the total (federal, and state) capital gains taxes that can be charged when a piece of real estate is sold in your state:
As you can see, no matter which state you’re looking at, capital gains taxes can take a pretty substantial percentage (%) of profit!
But wait, there’s more…
If the property you’re planning to sell had been used to generate income, and/or depreciated on your tax return, the amount that’s been depreciated would also be taxed in addition to the capital gains tax rates you see above!
So, in total, 20-40% of the profit being taken by taxes is a pretty safe estimate.
But it’s not all bad!
Luckily, if the property was held for investment, property owners can defer their capital gains tax payment by using either a Standard 1031 Exchange, or a Reverse 1031 Exchange.
Both Standard and Reverse 1031 Exchanges have the same general requirements:
- The property owner must engage with a 1031 Exchange Accommodator (like 1031 Exchange Advantage ® at SellTaxFree.com™) before closing on the sale, or purchase of their investment property.
- The property owner must sell a piece of investment property (that they already own), and
- Reinvest all of the cash (equity) from the sale, into new investment property (or, propert-ies) of equal or greater value within the required timeline.
- And finally, title on the replacement property must be held the same way that title is held on the property being sold.
The main difference between a Standard 1031 Exchange and a Reverse 1031 Exchange is the order of operations:
In a Standard 1031 Exchange, the property owner sells a piece of property (that they already own) FIRST, and purchases their replacement property (or, properties) SECOND.
In a Reverse 1031 Exchange, the property owner purchases their replacement property FIRST, and sells a piece of property, or properties (that they already own) SECOND.
As you can see, in general:
The Reverse 1031 Exchange is exactly what is sounds like it is; A Standard 1031 Exchange in Reverse!
Though a Reverse 1031 Exchange does have a few additional rules and requirements…
In a Reverse 1031 Exchange, proper documentation (commonly referred to as the “Reverse Exchange Agreement”) must be set up with a 1031 Exchange Accommodator (like 1031 Exchange Advantage ®) and signed by you, the Exchangor, before you close on your purchase.
Per IRS Regulations, the 1031 Exchange Accommodator will also request that a deed be created and returned to them, which will give them (or a separate entity that they operate) title to either the property you’re purchasing, or the property you’re planning to sell, depending on the preferred structure of the 1031 Exchange Accommodator that you’re working with.
Either structure is allowable by the IRS!
If your 1031 Exchange Accommodator takes title to the property that you’re purchasing (your replacement property), that is known as the “Exchange Last” structure.
Conversely, if your 1031 Exchange Accommodator takes title to the property that you’re planning to sell, that is known as the “Exchange First” structure.
The structure you use will just depend on the 1031 Exchange Accommodator that you work with. (And don’t worry, the Reverse Exchange Agreement outlines that the property will be deeded back to you before the exchange is over.)
Here at 1031 Exchange Advantage ® (SellTaxFree.com™), we use the “Exchange First” structure, and request a deed on the property you’re planning to sell, along with a Certificate of Insurance naming us as an “Additionally Insured” party on the property you’re planning to sell.
There are a few other documents that are required, but they’re usually the responsibility of the Escrow company, or Settlement Agent (Attorney) handling your purchase.
Let’s talk about what those are…
Rules (For Your Escrow / Settlement Agent, Upon Closing on Your Purchase):
Per IRS Regulations, if your 1031 Exchange Accommodator will be taking title (in the form of a deed) on the property you’ll be selling, they will also need a copy of the Final Closing Statement on your purchase, where they (or their special purpose entity) will need to be listed as the buyer of the property.
(Most Accommodators set up a special purpose entity to handle Reverse 1031 Exchanges, and request that that specific entity be listed as the buyer of the property. For example, at 1031 Exchange Advantage ®, we request that our special purpose entity, “1031 Funding & Reverse Corporation” be listed as the buyer on the closing statement for your purchase.)
Additionally, there is a document (supplied in your Reverse Exchange Agreement) called the “Seller’s Notice of Assignment by Buyer”, which must be signed by the seller of the property you are purchasing.
The main reason for this is that the IRS wants to be sure that the seller is made aware that you are buying the property as part of your 1031 Exchange. Take a look at the sample below:
If the seller won’t agree to sign the Notice of Assignment, for whatever reason, don’t worry! Though a signature is preferred, the IRS only requires that seller be put on notice, meaning you can send the Notice of Assignment to them via Certified Mail.
(Since Certified Mail gives you a receipt showing that the mail was delivered to the seller, it effectively gives you proof that the seller was given the Notice of Assignment, thereby satisfying the IRS’s requirement).
With that out of the way, let’s talk about the timeline…
Though your documents must be set up beforehand, your Reverse Exchange will effectively BEGIN on the day you close on the purchase of your replacement property.
If you’re unsure which date is the official closing date, the best date to use is the closing date listed on your Final Closing Statement.
In the event of an audit, that is the document that the IRS will use to determine the closing date.
Then, from the day you close on the purchase of your replacement property, you will have 180 days to close on the sale(s) of your relinquished property (or, properties).
Take a look at the graphic below for a visual summary:
I also put together a Reverse 1031 Exchange Infographic that outlines the rules and timelines, and can act as a great visual guide and overview. Just click below to download it.
Now you’re probably wondering, why would someone do a Reverse 1031 Exchange, instead of a Regular 1031 Exchange?
Well, there are pros and cons to each type of 1031 exchange….
Pros and Cons of a Reverse 1031 Exchange
Like I said at the beginning of this post, property owners can use either a Standard 1031 Exchange, or a Reverse 1031 Exchange to defer the payment of their capital gains taxes when they sell a piece of investment property. (Wondering which property types qualify as “Investment Property”? Click here.)
If an investor finds a great deal on a property they’d like to purchase before they’ve even considered selling one of their existing properties, the Reverse Exchange can be a GREAT option.
Rather than scrambling to do a Standard 1031 Exchange (sell first, buy second), and running the risk of the great deal they found falling off of the market, a Reverse Exchange allows them to close on their replacement property FIRST, and sell their existing property second.
Also, in a Standard 1031 Exchange, an investor has 45 days to identify the replacement properties that he or she is planning to purchase to complete his or her exchange.
An investor cannot change their mind after the 45th day, meaning if the identified properties fall off the market, or if the investor is out-bid by other buyers, their exchange will fail! (And they’ll be stuck paying the 30-40% in capital gains taxes that they were trying to avoid…)
On the contrary; In a Reverse 1031 Exchange, the investor is buying their replacement property FIRST, eliminating the risk they’ll run into the 45-day identification issue outlined above.
This gets rid of any of the pressure and stress that comes along with doing a Standard 1031 Exchange. (And who wouldn’t want less stress?!)
Reverse Exchanges do have their negatives as well:
Since a Reverse Exchange requires an investor to purchase property before their existing property has sold, it can be difficult to fund the purchase, and/or obtain financing, without access to the equity from the property they’ll be selling.
Furthermore, if an investor’s 1031 Exchange Accommodator is using an “Exchange Last” Reverse Exchange structure, where the Accommodator takes title to the property being purchased (the replacement property), some lenders are not comfortable making a loan for the purchase of the property since the Accommodator will be on title.
That being said, there are lenders that offer special programs for investors involved in a Reverse Exchange (and we can certainly help you find them).
Also, Reverse Exchanges do cost more money than a Standard 1031 Exchange, which brings me to my next topic…
How much does it cost?
Reverse 1031 Exchanges will always be more costly than a Standard 1031 Exchange.
Because there’s a lot more paperwork, and liability involved for the 1031 Exchange Accommodator!
Most Accommodator’s charge between $8,000 and $10,000 for a Reverse 1031 Exchange, though we’re able to set them up for just $5,995 at 1031 Exchange Advantage ® (this covers one purchase and one sale).
Still seem expensive?
We hear you! We offer a $1,750 discount for working with us on your purchase mortgage, and another $1,750 discount for working with our nationwide network of real estate agents who specialize in investment property. Clients who use both services bring their Reverse 1031 Exchange fee down to just $2,495! Call us for details.
We’ve gone over a lot so far, and in case you’ve gotten confused with any of the details, I wanted to walk you through a few examples of Reverse 1031 Exchanges to help make things clear.
Also, if you have specific questions on doing a Reverse 1031 Exchange, you can always schedule a free consultation with our team of 1031 Exchange Specialists. To schedule one, just click the button below:
Example #1 (Andy buys an Apartment):
This ^^ is an Andy.
Let’s say Andy finds a GREAT deal on an apartment he’d like to buy, and rent out to a tenant, in San Diego. The apartment costs $575,000 and he plans to purchase it with cash.
Andy also owns a single family rental property in Memphis that he’s been thinking of selling.
The fair market value of the Memphis property is around $400,000.
And finally, Andy is on title on the Memphis property as an Individual (in his personal name).
Because Andy is buying an investment property, and has plans to sell another investment property that he already owns, this is an awesome opportunity to set up a Reverse 1031 Exchange!
To do so:
FIRST: Andy sets up his Reverse 1031 Exchange with his 1031 Exchange Accommodator, at SellTaxFree.com, and signs all of his documents.
SECOND: Andy lets the escrow company handling his purchase know that he is doing a Reverse 1031 Exchange.
Per IRS guidelines, he also arranges for his escrow company to draw up a deed for his Memphis property (that he’s planning on selling) in the name of his 1031 Exchange Accommodator.
He also requests from his insurance company, that his 1031 Exchange Accommodator be named as an “Additionally Insured Party” on his Memphis property.
THIRD: Andy closes on his San Diego apartment purchase for $575,000 in cash, and is sure to be listed on title as an Individual (the same way that he’s listed on title on the Memphis property he’ll be selling).
FOURTH: Andy closes on the sale of his Memphis property within 180 days of closing on his San Diego apartment purchase, and his sales proceeds of roughly $200,000 are sent to his 1031 Exchange Accommodator.
Since Andy purchased his San Diego apartment with all cash, his $200,000 in sales proceeds from his Memphis sale can be disbursed to him directly.
Why does that matter?
Remember: An investor must make sure to have at least the same amount of cash (equity) in the property they purchase, as was in the property that they sold, before the end of the exchange period (day 180).
The price of the property they purchase must also be equal to or greater than the price of the property that they sold.
So, since Andy purchased his San Diego apartment for $575,000, and sold his Memphis property for $400,000, he is good to go!
AND THAT’S IT! Woo-hoo Andy!
Example #2 (Victoria buys a Vacation Rental)
This ^^ is Victoria.
Let’s say Victoria is about to buy a property in Park City, Utah and rent it out on Airbnb and VRBO.
The property costs $700,000 and Victoria will use $100,000 cash and a $600,000 loan to purchase the property.
Victoria also owns 50% of a commercial building in Dallas that she is planning on selling, and holds title in her Single-Member LLC.
The Dallas building could sell for roughly $1,000,000 (though Victoria’s 50% portion is worth only $500,000).
Again, because Victoria is buying an investment property, and has plans to sell another investment property that she already owns, this is an awesome opportunity to set up a Reverse 1031 Exchange!
To do so:
FIRST: Victoria sets up her Reverse 1031 Exchange with her 1031 Exchange Accommodator, at SellTaxFree.com, and signs all of her documents.
SECOND: Victoria let’s the escrow company handling her purchase know that she is doing a Reverse 1031 Exchange.
Per IRS guidelines, she also arranges for her escrow company to draw up a deed for her portion of the Dallas commercial property (that she’s planning on selling) in the name of her 1031 Exchange Accommodator.
She also requests, from her insurance company, that her 1031 Exchange Accommodator be named as an “Additionally Insured Party” on her Dallas commercial property.
THIRD: Victoria closes on her Park City purchase for $700,000, using $100,000 in cash, and a $600,000 loan. She is also sure to take title to the property in the same Single-Member LLC that she holds title to her Dallas commercial property in.
FOURTH: Victoria closes on the sale of her Dallas commercial property within 180 days of closing on her Park City purchase, and her sales proceeds are sent to her 1031 Exchange Accommodator.
Since Victoria purchased her Park City property with only $100,000 in cash, and a $600,000 loan, her proceeds from the sale of her Dallas commercial property must be used to pay down her $600,000 mortgage, so that she has at least the same amount of cash (equity) in the Park City purchase, as was in the Dallas commercial property sale, before the end of the exchange period (day 180).
Why does that matter?
Again, remember: An investor must make sure to have at least the same amount of cash (equity) in the property they purchase, as was in the property that they sold, before the end of the exchange period (day 180).
And finally, since the price of her Park City property ($700,000) is equal to or greater than the price of the Dallas property that she sold (50% of $1,000,000 = $500,000), she has met the IRS requirements of her Reverse 1031 Exchange!
AND THAT’S IT! Go Victoria! Go Victoria!
Hopefully by now, you’re starting to get a good idea of how the Reverse 1031 Exchange works, and how it can benefit you as a real estate investor.
(If you’re interested in learning more about how Standard or Reverse 1031 Exchanges can help you grow your real estate wealth, check out our awesome Real Estate Wealth Building Guide, register for a webinar, or schedule a free consultation with a 1031 Specialist.)
And if you’re ready to get started with your Reverse 1031 Exchange, we’ve got you covered…
How to Get Started
First and foremost, your Reverse 1031 Exchange must be set up with a 1031 Exchange Accommodator BEFORE you close on your purchase! (That’s absolutely crucial!)
To get your documents set up, simply click here, or call 866-944-1031 to get assistance in setting the documents up over the phone.
And that’s it! Was there anything that confused you? Anything that was unclear? Did you learn something new? Let me know in the comments below!
And, as always, if you have any questions on your specific situation, or how 1031 can work for you, you can always schedule a free consultation with a 1031 Exchange Specialist at PlentiFinancial.com.