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October 19, 2021

Real Estate Investing in a Seller’s Market: How a Reverse 1031 Exchange Can Help Defer Tax on Capital Gains

A 1031 exchange, otherwise known as a “like-kind exchange”, is a common tax strategy for real estate investors buying and selling property. A reverse 1031 exchange is a lesser-known strategy but can be very beneficial in a seller’s market where investors need to act on new properties quickly. Below we discuss the difference between 1031 and reverse 1031 exchanges and what qualifies for a reverse 1031 exchange.

What is a 1031 or Like-Kind Exchange?

A 1031 exchange allows real estate investors to defer recognition of income on real estate transactions. Investors can carry the profit on the exchange into a new replacement property. If the entire profit from the exchange of the property is invested in the new property, the taxpayer is allowed to defer tax on the full gain.

What is a Reverse 1031 Exchange?

A reverse 1031 exchange differs from a normal 1031 exchange because of the timing of the acquisition and relinquishment of the properties. A conventional 1031 exchange requires the taxpayer to relinquish property before they acquire new property. A reverse 1031 exchange allows the taxpayer to acquire the new property before they relinquish the old property.

A reverse 1031 exchange is beneficial in a seller’s market. It allows a taxpayer to secure a new property quickly and still qualify to defer recognition of income when they sell an old property within 180 days.

Does My Transaction Qualify as a Reverse 1031 Exchange?

To qualify as a reverse 1031 exchange, the following requirements must be met:

  1. The replacement property must be transferred to an Exchange Accommodation Titleholder (EAT). The EAT can be set up as a single member LLC and is used so the taxpayer is not the owner of the property.
  2. When the property is transferred to the EAT, it must be the taxpayer’s intent that the property is the replacement property.
  3. Once the EAT is the holder of the property, the exchanger has 5 days to set up a Qualified Exchange Accommodation Agreement (QEAA).
  4. Within 45 days after the transfer, a relinquished property must be identified.
  5. The taxpayer has 180 days after the initial transfer into the EAT to move all properties out of the QEAA and finish the exchange.

To qualify, the taxpayer must newly purchase the replacement property.

What Can Reverse 1031 Exchange Funds be Used For?

There are also stipulations around how eligible funds can be used. The exchange funds can only be used to:

  • Purchase the replacement property
  • Pay closing costs, or
  • Pay off a mortgage on the relinquished property

The taxpayer cannot use the exchange funds to pay the mortgage or build on to an already owned property. If the exchange funds are used in these manners, then the funds must be recognized as a gain.

To find out if your transaction qualifies for a 1031 exchange or reverse 1031 exchange, contact an Anders advisor below to talk to our real estate advisors.  

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