Real estate investors may be familiar with traditional tax-deferred exchanges like 1031s that involve selling a property and then buying a similar or “like-kind” replacement property.
The lesser-known “reverse” 1031 exchange involves acquiring a replacement property before the relinquished property is transferred. It can work in situations where a forward 1031 wouldn’t relieve a taxpayer of having to recognize taxable gain.
“Generally, real estate investors often show interest in learning more about this technique, especially when the real estate market is strong,” said Jim Rabasca, senior tax specialist at Summit Financial in Parsippany, N.J.
“Tax implications are generally the same as in forward exchanges,” said Tim Trifilo, partner in the tax services group at Crowe in Washington, D.C. “The ultimate goal is to defer the gain recognized by the disposition of the relinquished property.”
The strategy involves detailed planning and timing, advisors said.
Reverse 1031 rules require the use of an “exchange accommodation titleholder,” an unrelated party who holds legal title until the relinquished property can be sold subject to a timely “qualified exchange accommodation agreement” (QEAA). The titleholder is also sometimes known as an “exchange administrator” (EA).
In one main method of a reverse 1031, at the closing of a replacement property’s purchase, evidence of the property ownership, otherwise known as the “qualified indicia of ownership,” is transferred to an exchange accommodation titleholder. “A written QEAA is then executed at the same time or within five days of the transfer,” said Michael Torhan, tax partner in the Real Estate Services Group at EisnerAmper in Syosset, N.Y.
The qualified exchange accommodation agreement provides that the titleholder holds the property for purposes of a reverse 1031; that the titleholder and taxpayer agree to report the acquisition, holding and disposition of the property; and that the titleholder is treated as the beneficial owner of the property for tax purposes.
“Generally, the client has to lend funds to the [exchange administrator] for them to purchase this property, and generally the EA uses a new single-member LLC to acquire the replacement property,” said Jason Vanden Bosch, a CPA and senior managing director at CBIZ MHM in Chicago.
“Within 45 days of the [titleholder’s] receiving title to replacement property, a taxpayer must identify the property he or she will relinquish through the exchange,” Rabasca said. The intermediary then takes title to that relinquished property. “Sale of relinquished property and acquisition of replacement property must be completed within 180 days.”
“Once the relinquished property is sold, the proceeds go to the EA just like in a normal forward exchange. The EA uses the proceeds to repay the loan from the client and transfers the interest to the client,” Vanden Bosch said.
Exchange administrator fees for reverse 1031s tend to be higher than those for forward 1031s, he added.
Analysis of any cost-recovery/depreciation related to the transactions is key, Trifilo said, as are any improvements needed to the replacement property. “Ensuring that the taxpayer doesn’t hold title to both properties at the same time is also important,” he added.
It can obviously be easier to find a property to sell in 45 days than it can be to find one to buy in that same amount of time, Torhan added, though “the 180-day requirement to close on the sale of the property may create pressure. The taxpayer must find a qualified buyer, negotiate an acceptable sales price and close on the sale transaction.”
People will also have to consider the financing for the replacement property that’s acquired at the beginning of the reverse 1031, as the titleholder will be named the borrower on any loan, and also consider that the taxpayer will be unable to claim depreciation on the property while the property is owned by the titleholder.
Beware things that generate gain: The receipt of cash or mortgage boot (the cash or value of the non-like-kind property). Certain types of non-real property, such as personal property, could also trigger a gain.