When to Consider a 1031 Reverse Exchange

A 1031 Reverse Exchange allows real estate investors to acquire investment property prior to relinquishing their current investment and to defer any capital gains taxes. The 1031 section of the IRS code states that an investment property can be exchanged for a like-kind property and the deferred tax will not be due until the purchased property is re-sold. In a typical 1031 exchange a property is sold and the owner, or taxpayer, has 45 days to locate a replacement property of equal or greater value and 180 days total to complete the exchange. However, these timeframes have created a challenge for investors to follow. The IRS came up with the reverse exchange to address some of these challenges. Ask yourself the following questions to determine if the 1031 reverse exchange is right for your investment portfolio.  

How Hot is Your Market?

The conditions of your market could limit your ability to complete a successful 1031 Exchange. In markets where properties are selling fast, a reverse exchange will eliminate the need to identify a property within 45 days from the sale of your current property. Since you will be acquiring the replacement property first, you will have the luxury of taking your time to find a good investment. Also, if you have financing in place, you don’t have to take the risk of losing the property to another buyer.

Do You Have Your Own Financing?

What if an exchanger doesn’t have financing in place? This is where a reverse exchange can get tricky since you won’t have the proceeds from the sale of your current property available, and a Qualified Intermediary (QI), acting as an Exchange Accommodating Titleholder (EAT), will either have to go on your current property’s title, or take title to the replacement property for you. The IRS will not allow an owner to exchange between their own properties. If you expect your EAT to take title to your replacement property, your lender will be hesitant to fund them a bridge loan. If you want the EAT to take title to your current property, the exchanger must provide a cash advancement to the EAT equal to the equity in your home, so they can purchase it. With either scenario, be prepared to come up with your own financing.

Will Your Exchange Require More than 180 days to Complete?

Safe harbor reverse exchanges can be completed within 180 days. If the exchange requires additional days to be completed, it is considered a non-safe harbor exchange. Most improvement exchanges will take longer than 180 days to complete. These exchanges usually involve construction work on a property to match the value of the other property being exchanged. The relinquished property still must sell within 180 days even if you’re conducting a non-safe harbor reverse exchange. Safe harbor guidelines are not mandatory, although you will run a high audit risk if you decide to extend your exchange outside of 180 days. In case of an IRS audit, a non-safe harbor exchange must stand on its own merit with documentation to justify the extension.

Is Your Tax Deferral Worth Paying the EAT Fees?

The EAT fees associated with a reverse exchange are more substantial than a typical 1031 Exchange. These fees include the additional documentation a reverse exchange requires and the risk of taking title of your property. If the reverse exchange fees outweigh your tax liability, you may want to consider a typical 1031 Exchange or holding on to your investment.

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