1031 Exchange Guidelines: Reverse Exchange Primer
In a typical 1031 Exchange, relinquished property is sold first and then replacement property is purchased. On occasion, it may be advantageous to do the reverse; purchase replacement property first and then sell relinquished property. Such a process is appropriately named “Reverse Exchange” and is an accepted method of exchanging under current tax law (Revenue Procedure 2000-37).
A reverse exchange presents three notable challenges:
First, the relinquished and replacement properties cannot be owned by the investor at the same time. Therefore, an Exchange Accommodating Titleholder (EAT) a.k.a. Qualified Intermediary, will take title to the replacement property. The qualified intermediary working on the exchange will generally set up the EAT. After the EAT takes title to the replacement property, the investor will have the normal 180 days to complete the exchange by selling the relinquished property.
The second challenge is financing the replacement property. Funds need to be available for the purchase of the replacement property prior to the sale of the relinquished property. An investor contemplating a reverse exchange will need to have all cash available to spend out of pocket. Since the 1031 tax deferred exchange accommodating titleholder (EAT) a.k.a. Qualified Intermediary will acquire title to the replacement property, a lender will generally not lend money to the EAT. Almost always, a reverse exchange requires the investor to purchase the replacement property all cash.
Once the reverse exchange is completed, the investor will be returned excess money deposited to facilitate the reverse exchange without incurring boot, as long as the money returned is equal to or less than the additional money on deposit with EAT.
Third and finally, a reverse exchange will add several thousand dollars in additional exchange fees and closing costs to the exchange transaction which makes it the most expensive method of exchanging.
The preferred method of completing a 1031 tax deferred reverse exchange is for the EAT to take title to the replacement property in an all cash purchase. However, it is sometimes possible for the EAT to take title to the relinquished property. It is also possible for the EAT to take title to the replacement property and for a loan to be part of the purchase price. Such alternative structures are rare and often difficult to accomplish. Select a lender who is able to work with you and the 1031 Exchange Qualified Intermediary before considering a Reverse Exchange.
1. The funds used to acquire the replacement property must be advanced by the investor as a loan to the EAT. The EAT will pay back the loan after the relinquished property is sold.
2. The investor will have full access to the replacement property during the EAT ownership and can rent the property immediately.
3. In order for the EAT to take title and then transfer ownership to the investor, a single member LLC will usually be used. At the completion of the exchange, the EAT will generally transfer the LLC to the investor rather than recording a deed. Transferring the LLC to complete the exchange will likely save on transfer taxes but will require the investor to manage the LLC after the completion of the exchange.
4. Reverse exchange also requires specific and unique tax reporting at year end and the Qualified Intermediary will assist with such reporting.
For assistance in finding a gem of a home, contact Sam. With 27 years of experience he knows where to find the home of your dreams.
Arizona Associate Broker, CRS, GRI, e-PRO, SFR
Berkshire Hathaway HomeServices Arizona Properties
Call: 480-213-1799 or Contact Sam for Investment Guidance and to discuss your plans to purchase a Phoenix home for sale and schedule an appointment to see how he can help you achieve your real estate investment goals.