Take Advantage of the Early Purchase

All too often, I’ve seen potential 1031 exchanges fall apart because the seller was either unable to get the price they wanted, or the buyer backed out or couldn’t get the loan approval they needed. I’ve also watched many investors lose out on the purchase of their new dream replacement property because they couldn’t close in the required timeframes. In these instances, sellers often could have moved forward with their exchanges had they been aware of a lesser-known option called the reverse 1031 exchange.

The reverse 1031 exchange is a tax-deferral strategy permitted by the Internal Revenue Service that enables a seller to purchase a replacement property before they close on the property they are relinquishing.

Key Advantages

One of the advantages of the reverse 1031 exchange is that in compelling markets where inventory is tight, a seller can take the necessary time to find the perfect replacement property without being rushed under the restrictive deadlines of a traditional 1031 exchange, and potentially making a poor purchasing decision. The reverse 1031 exchange can also be a valuable tool when the seller is unable to close on the sale of their relinquished property, which can happen for a variety of reasons. In this case, the seller is still able to purchase the desired replacement property and is afforded up to 6 months to sell the existing property. That takes a lot of pressure off.

Different Rules Apply

Many investors considering a 1031 exchange have a basic understanding of the rules and regulations that apply. A reverse 1031 exchange has its own set of rules and they need to be strictly adhered to. Also, these are complex strategies and you should always discuss any potential transactions with your advisor, attorney and tax specialist before entering a reverse 1031 exchange. 

One of the most important things to understand, and where some investors get tripped up, is knowing you cannot hold title to both the un-relinquished and replacement property at the same time. To satisfy this requirement, you need to engage an Exchange Accommodation Titleholder (EAT) which is a single-purpose LLC formed for the purpose of holding or parking title throughout the process. The EAT serves a critical function in the reverse 1031 exchange process which is outlined here:

General steps you’ll follow with a reverse 1031 exchange:

• Identify a replacement property (of equal or greater value). Be certain the contract allows for the transfer of title to your EAT
• Enter into a qualified exchange accommodation agreement between you and your EAT
• The EAT acquires title once financing has been arranged
• Identify the relinquished property within 45 days of the EAT acquiring title on the replacement property
• Identify a buyer for the relinquished property within 135 days of when you identified the replacement property. Enter into a contract with the buyer
• Enter into a new agreement with a Qualified Intermediary (Q1) to facilitate the completion of the traditional 1031 exchange part of the transaction. The QI will handle titles on both the relinquished and replacement properties
• Deliver the deed to the buyer, and then proceeds will be handed to the QI. The QI will then use those funds to acquire the parked property from your EAT.
• Receive your deed on the replacement property

Risks and Considerations

As you evaluate the benefits of a reverse 1031 exchange, it’s always important to consider potential risks. A few of those include:

• You may need to have readily available cash to close on the replacement property while you’re waiting on the proceeds from the relinquished property. On larger transactions, this can often be challenging
• You might have difficulty gaining loan approval on the replacement property. Some lenders may be averse to participating in a transaction where the EAT holds title
• You may have difficulty selling your relinquished property within the 135-day designation timeframe which would cause the transaction to fail

I recognize this is a lot of information and it may seem confusing. As mentioned, these are complex tax-deferral structures that required guidance from qualified experts. I’ve personally helped dozens of clients with their reverse 1031 exchanges and have proven time-and-again that these can be an efficient and effective tool for real estate investors. If you would like to learn more about the reverse 1031 exchange or to view our portfolio or potential replacement properties, please call me at 646-340-5993.