The potential for tax savings is one of the most exciting advantages of real estate investing. Many savvy investors have enjoyed the benefits of deferring their capital gains taxes by engaging in a 1031 exchange.
This process involves replacing an investment property with a “like-kind” property. When done correctly, investors can avoid paying capital gains taxes on the sale of the original property. Even better, it’s possible to continue doing this repeatedly so you have the potential to build even greater wealth as you upgrade from one property to the next. However, this technique has some limitations.
Property investors looking for even more flexibility may want to consider a reverse 1031 exchange. Here's what you need to know.
Reverse 1031 Exchange: The Basics
When engaging in a traditional 1031 exchange, you must sell your original property before you can purchase a replacement property. The major drawback here is that if the original property takes a long time to sell, you could miss out on your opportunity to buy the perfect replacement property.
This is where a reverse 1031 exchange comes in. As you might guess, this transaction completely reverses the process.
First, you’ll start looking at properties you want to purchase as a replacement property. When you find one, you’ll work with a qualified intermediary to facilitate the transaction.
Once you close on your new property, you have a maximum of 45 days to identify the property you plan to sell. You’ll also have a total of 180 days to close on the property sale, completing your reverse 1031 exchange.
The Role of a Qualified Intermediary
In a traditional 1031 exchange, a qualified intermediary (QI) is needed to ensure the investor doesn’t take real or constructive possession of the investment funds at any time. Otherwise, the 1031 exchange can be invalidated, and the investor would owe all or some of the capital gains tax.
When engaging in a reverse 1031 exchange, there are a couple of different ways the QI may interact with investors. One method involves investors purchasing the replacement property themselves and then transferring the title of the original property to the QI.
The other is for the QI to purchase the property using financing provided by the investor and then turning the property’s title over to the investor once the original property sells.
Pros and Cons to Consider
The biggest advantage of engaging in a reverse 1031 exchange is the ability to purchase a replacement property whenever the opportunity arises. This is particularly important when there’s a lot of demand for the types of properties you’re looking for.
However, there are a few potential disadvantages. First, you’ll need to sell the original property within 180 days, or you’ll lose the favorable tax treatment. It’s difficult to guarantee a property will sell, so there’s some inherent risk in this. You’ll also need to have enough money to purchase the replacement property before you’ve received the proceeds from the sale of the original property. Unless you have a significant amount of cash on hand, you may find that you have difficulty persuading a lender to provide you with the financing you need.
Other Important Considerations
There are a few other important things you need to know. First, the property rules are the same with a reverse 1031 exchange and a traditional 1031 exchange. Both properties must be “like-kind,” held for investment or business use, and must be located in the United States.
If the new property costs less than the original property, you’ll also owe capital gains taxes on the difference. The same is true if the value of the new replacement property is less than the sold or relinquished property, keeping in mind you can replace debt by adding equity, but you may not replace equity by adding debt.
The Bottom Line
If you’ve found the perfect replacement property, using a reverse 1031 exchange can allow you to lock it in without having to wait for the sale of your original property. However, unless you’re confident you can close on the sale of the original property within the 180-day timeframe, you’re taking a bit of a risk.
Before deciding to engage in a reverse 1031 exchange, it’s a great idea to discuss your specific circumstances with your tax professional, financial advisor, and, in some cases, a real estate professional.
If you have additional questions regarding traditional or reverse 1031 exchanges, Fortitude Investment Group is here to help. Contact us today to schedule a consultation.