Real estate investors may know traditional tax-deferred exchanges like 1031s that typically 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 involved detailed planning and timing, advisors said.
Reverse 1031 rules stipulate 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, “qualified indicia of ownership” of the property 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 QEAA 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 EA 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] 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."