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A Guide To Understanding Reverse Exchanges

Want to utilize a 1031 exchange but need to close on your replacement property first? You should consider a “reverse” 1031. These transactions are more complicated and challenging than standard exchanges, but our company has decades of experience helping investors navigate the reverse landscape.

How To Do a Reverse 1031 Exchange

A brief overview of the process of a reverse 1031 exchange

  1. You have a property you want to sell. This is Property A.
  2. Before you sell Property A, you find a new property you want, Property B. The IRS says that the taxpayer may not own both properties at the same time if they want to do a 1031 exchange.
  3. A qualified intermediary, like 1031x, purchases and holds Property B until you sell the Property A.
  4. Once Property A is sold (within 180 days), Property B is transferred to you and the capital gains are deferred.

Breakdown of Reverse 1031 Exchanges

In this post, is going to break down 1031 reverse exchanges to help you understand the process and see if you qualify. Before we start talking about 1031 reverse exchanges, it is important to understand what a 1031 exchange is. Section 1031 of the Internal Revenue Code gives us the ability to exchange your existing property for a new property without triggering capital gains tax. Capital gains tax is simply a tax levied on profit from the sale of property or of an investment. Section 1031 that has been in the code since 1921. While it has been enhanced and tested by case law since that time, it was Revenue Procedure 2037 approved in September of 2000 which codified the safe harbors for 1031 exchanges done in reverse.

“Reverse 1031 exchanges are an exceptionally powerful tool for clients when they already own a property.”

A reverse 1031 exchange is simply where the new property is attained before the old property is sold. Thereby, enabling the taxpayer to accomplish a qualifying like-kind 1031 exchange. Reverse 1031 exchanges are an exceptionally powerful tool for clients when they already own a property. In a reverse 1031 exchange, the client must act on the purchase of the new property immediately. Section 1031 of the Internal Revenue Code prohibits the client from owning both the new property and the old property at the same time while still being eligible to get capital gains tax differed treatment. Reverse 1031 exchanges are not for the faint of heart. Reverse 1031 exchanges take time to complete and are not a quick process. Luckily, the complicated process of a reverse 1031 exchange is usually managed by your accountant, Realtor, accommodator, and title company. Your only job is to pay the bill.

In reverse 1031 exchanges, you only have 45 days to identify the property to sell and 180 days to close escrow. Reverse 1031 exchanges work to preserve the tax deferral. This is most helpful for prospective clients that have identified the property that they want to attain (replacement property) before they have found a buyer for their existing property (relinquished property). Since the real estate market can change so quickly, it may take longer to sell your current property. At the same time, you don’t want to miss the opportunity to acquire the new property while the price is right.

A Qualified Exchange Accommodation Arrangement or QEAA is created by a qualified intermediary who acts as the Exchange Accommodation Titleholder or “EATs”. The Qualified Exchange Accommodation Arrangement temporarily holds the real estate investor’s relinquished or replacement property. Having a Qualified Exchange Accommodation Arrangement (QEAA) helps investors comply with Section 1031 of the Internal Revenue Code and allows investors to defer taking a capital gain or loss on the sale of real estate as long as the relinquished property is replaced by a “like-kind” property. Qualified Exchange Accommodation Arrangements (QEAA) are very particular in their format for the sale and purchase of like-kind properties, but do allow flexibility in the timing of the sales and simplify the investor’s ability to qualify for the tax deferral.

Example of a Reverse 1031 Exchange

Let’s break down the process of a reverse 1031 exchange with an example. A client, Luner LLC identified a target property that was only available if Luner LLC could acquire it before the end of the month. Luner LLC wanted to sell four of its existing properties to fund the transaction. We describe the mechanism that could accomplish the transaction noting that the code requires that the owner cannot be by the taxpayer or a disqualified person and that the taxpayer must have a bona fide intent to treat the transaction as a reverse 1031 exchange.

Now it is time to make an agreement using, Inc. (the Qualified Intermediary) to create a single purpose entity, “Conor Inc.”, to hold the title to the desired property. Once the Exchange Accommodation Titleholder (EAT) was created and the agreement signed by the client, Conor Inc. was positioned to attain the new property. The purchase was funded by means of an equity loan that Luner LLC arranged with its lending institution using the existing property equity positions loan to Luner LLC and a first mortgage on the new property with Conor Inc. as Borrower and the principal of Luner LLC is guaranteed. Conor Inc. acquired title to the target property and leased it to Luner LLC for its immediate use. In the meantime, Luner LLC listed its four existing properties for sale and within 45 days of Conor Inc. acquiring the target property and identified these three properties to, Inc. (the Qualified Intermediary).

Luner LLC went to work to see as many properties that it could within 180 days so that the target property could be deeded from Conor Inc. to Luner LLC. Luner LLC was diligent in its sale of the existing properties but was only able to sell two of the three identified for sale. The sale proceeds of the two that did sell were passed through to the qualified intermediary and just prior to the 180th day. The equity loan was paid down and the target property was deeded from Conor Inc. to Luner LLC.

Timeline of a Reverse Exchange

  1. When you purchase an investment property, your tax basis is created based on the acquisition cost. This will impact the taxes you pay when you eventually sell the property. To get your tax basis, you calculate the acquisition price plus the acquisition costs plus improvements during the time you own the property minus depreciation.
  2. Let’s pretend you purchased a residential property 20 years ago and you have rented it for the past 15 years while making improvements and repairs. You have also been taking depreciation as well. Now, this property has a basis of $30,000 and a current market value of $300,000.
  3. Say you refinanced three times and now owe $250,000. If you sell this property for $300,000, your gain will be $270,000. Between both state and federal taxes, you might have a tax liability of as much as $70,000. After some calculations, you’ll also find that you owe $20,000 to be able to sell the property.
  4. This now becomes a 1031 exchange. In most 1031 exchanges, you would sell Property A and attain Property B. As long as Property B requires the same or more debt or equity as Property A, you are able to postpone paying taxes until a time in the future. In a reverse 1031 exchange, the taxpayer wants to buy their replacement property before they sell their relinquished property.
  5. Say you found Property B before you sell Property A. The IRS says that the taxpayer may not own both properties at the same time. This begins the reverse 1031 exchange procedure.
  6. The procedures, approved by the IRS, are for an independent, unrelated entity be set up to hold either the relinquished property or the replacement property in order to satisfy the requirement that you do not hold title to both properties at the same time.
  7. In the most common reverse 1031 exchanges, our holding company buys the replacement property (Property B) and holds it for you until you sell the relinquished property (Property A). Sometimes that procedures do not work because the loan that you have already arranged on your replacement property will not allow our holding company on the title. In those cases, 1031x must use the alternative procedure where we hold title to your relinquished property (Property A). This procedure is also approved by the IRS, though it is less common.
  8. At this time, you get the money for the down payment on Property B before you sell Property A. You then have 45 days to identify a property to sell and 180 days to close escrow.
  9. Once Property A has been sold, Property B is now your property and you do not have to pay capital gains tax on Property A.

Relinquished Property and 1031 Reverse Exchanges

  1. The relinquished property is the property the investor is selling. In a reverse 1031 exchange, the exchanger has found and wants to buy the replacement property before their sale of the relinquished property.

    In 2000 in Rev Proc. 2000-36, the IRS set forth the procedures to safely accomplish a reverse 1031 exchanges. In a reverse 1031 exchange, the IRS has given us this problem to solve:

    If the exchanger owns both the relinquished property and the replacement property at the same time, the IRS will not consider the transaction to be an exchange of real estate.

    Therefore, either the replacement property or the relinquished property must be held, temporarily, by a holding company known as an Exchange Accommodation Titleholder (EAT).

What Happens Next?

  1. Our Limited Liability Company buys the relinquished property. The LLC will act in the capacity of an Exchange Accommodation Titleholder (EAT) as that term is defined by the IRS. The EAT and the exchanger will enter into a real estate holding contract termed by the IRS a Qualified Exchange Accommodation Arrangement (QEAA). The QEAA will outline the obligations of the EAT and the exchanger during the real estate holding period.
  2. Our LLC will purchase the relinquished property by borrowing 100 percent of the needed funds. We can borrow the funds from any source authorized by the exchanger. The easiest source of borrowed funds in the exchanger themselves. Because we plan to resell the relinquished property very quickly, we often leave any existing financing in place on the relinquished property and take title to the property subject to the existing financing. The lender is protected by a note and deed of trust on the relinquished property. Finding a lender for a reverse exchanger can be difficult. Please contact us is you need help finding a reverse exchange lender.
  3. Our LLC will also lease the relinquished property to the exchanger until the relinquished property sells, or for 180 days, whichever occurs first. Lease payments from the exchanger to Our LLC will correspond in amount to mortgage payments made by Our LLC.
  4. Our LLC will also agree to re-sell the relinquished property to a third party buyer. We list the relinquished property for sale with a real estate broker of the exchanger’s choosing. We must resell the relinquished property to a third party buyer within 180 days after Our LLC acquires the relinquished property. The 180-day time limit for completing a reverse 1031 exchange is set by the IRS.
  5. At the time of sale of the exchanger’s relinquished property,, Inc. will act as Qualified Intermediary for the exchanger and escrow the funds from the sale of the relinquished property. Net proceeds from the sale of the relinquished property will be used to buy replacement property, from Our LLC. THE NET EFFECT OF THIS WILL BE SIMPLY TO SHIFT ALL EQUITY FROM THE RELINQUISHED PROPERTY TO THE REPLACEMENT PROPERTY. In the end, this looks very much like a forward exchange with us having captured and held the relinquished property until a third party buyer can be found.
  6. When we hold the relinquished property these types of reverse exchanges are also known as exchange first reverse exchanges because the 1031 exchange actually takes place when the relinquished property is transferred to Our LLC.

Relinquished Property and 1031 Reverse Exchanges

  1. The relinquished property is in Louisville. Its value after sale costs is about $400K.
  2. The replacement property is in Boulder. Its value is about $1.15M. You have arranged for a down payment on Boulder of about $400K with the balance financed by a conventional lender.
  3. You lend our holding company $400K which we use to buy Louisville. You no longer own this property. But you do have a deed of trust on the property that shows that you loaned us the money and it will need to be repaid to you when Louisville sells to a third party.
  4. We list the Louisville property with a real estate broker of your choosing. You continue to make decisions about Louisville, even though we own it.
  5. The $400K flows through a 1031x account and becomes the down payment in Boulder.
  6. The net effect of the transaction is to transfer your equity in Louisville to Boulder.
  7. Once you decide to proceed we will need the address of the Louisville property and the purchase contract and title work on the Boulder property.

What happens when a reverse 1031 exchange fails?

When a reverse exchange fails, our real estate holding agreement states that we will transfer whatever property we are holding to you at the end of 180 days. You end up owning both relinquished property and replacement property. A failed reverse exchange is not a tax recognition transaction. You just own more real estate than you had hoped.

We hope that you found this information on reverse 1031 exchanges useful. Before you decide to leap into any complicated financial decisions, please be sure to discuss them with people trained to provide expert accounting advice. 1031x has over twenty years of experience with all types of 1031 exchanges nationwide. would be happy to help you with any advice or questions you may have regarding 1031 exchanges. 1031 Exchanges are our business!