Real Estate

Capital Tax Deferrals on Real Estate Investments: What Is a Reverse 1031 Exchange?

Capital Tax Deferrals on Real Estate Investments

Over the years, the American real estate industry has been lucrative for both new and existing investors. It’s also got an upward positive outlook over the next few decades. Typically, the goal is to profit from property sales, purchases, or rent as legally possible.

However, taxes are an essential component in the real estate industry, as any investor would readily tell you. They’d determine your profit margins over a short or long period and the general viability of your investment choice. 

You must also understand that taxes are compulsory and often immutable. However, while you can’t avoid paying taxes on your real estate investments, you can avoid incurring them in the first place using some legal methods. 

One such application is the reverse 1031 exchange, which allows you to buy and sell investment properties without attracting the capital gains tax. How does a typical reverse 1031 exchange work? What other requirements would you need to complete the process? This piece outlines the lifecycle of a reverse 1031 exchange and how you can use it for your investment benefits. 

What Is a Reverse 1031 Exchange in Real Estate

As previously mentioned, the goal of any real estate investor is to maximize profits on property trades. You may have found yourself discussing with your real estate agent some ways to optimize your investment portfolio. They might have tried explaining reverse 1031 exchange to you in the process. 

So if you have been asking, what is a reverse 1031 exchange? It involves buying a property and selling an existing one in its stead to get an exemption from paying the capital gains tax. It’s the reverse because a regular 1031 exchange requires that you sell an old property first, then use the proceeds to purchase a new one. 

Drawing on a typical reverse 1031 exchange diagram, the investor only has 180 days to complete the sales process of the old building immediately after buying a new property. Also, both properties have to be of the same category (as recognized by the Internal Revenue Service) for you to be eligible for a tax deferral.

Reverse 1031 Exchange Requirements

Before you initiate a reverse exchange real estate process, it’s essential to understand the preliminary requirements you’d need. Also, the investment method has some regulations, like that only investment properties are eligible – you may include vacation homes or commercial buildings but not personal residential ones. The following are the other details you need to know:

  • Property Value Statements

First, an investor has to acquire a recent property value statement for the purchased property and that which is about to get sold. Both assets must at least have an equal market value, and if there’s to be an imbalance, it’s to favor the newly purchased property.

If the older building has a higher value, you will incur capital gains tax on the surplus profit after the sales, nullifying any reverse 1031 exchange benefits. 

  • Purpose of Fund

The investor must use all the proceeds from selling the old property to fund the newly-purchased one. In some cases, the money goes into mortgage servicing or maintenance. However, you might have settled the financing for the new purchase elsewhere before selling the old property. In such situations, you’d still have to file the exchange sales proceeds under purchase costs instead of personal income. 

  • Collecting Like Properties

You can only initiate the reverse 1031 exchange process on investment properties of the same category. The reverse like kind exchange rules states that a residential building can only get exchanged with another residential property. In like-kind exchanges, you may consider variations under each category. For instance, a single-family home could go for a multifamily one, even as they’re both residential properties.

  • The Process Window

Before you set a reverse 1031 exchange process in motion, you must have identified the asset you wish to sell within 45 days of buying the new one. Once the new purchase is complete, you must also complete the old property’s sales process within 180 days.

The Reverse 1031 Exchange Process

What is a reverse 1031 exchange process like for most investors? The process is in tiers, and the following are the steps you must follow:

  • Identifying An EAT (Exchange Accommodation Titleholder)

The first step in the reverse 1031 exchange timeline is identifying and securing an EAT (Exchange Accommodation Titleholder). They’re the entity that would agree to hold the title of the new property you’re about to acquire. From that point forward, the EAT would represent you throughout the exchange process, and you’d have to sign a QEAA (Qualified Exchange Accommodation Agreement) with them. It’s one of the reverse 1031 exchange documents where the investor enters an agreement with third parties.

  • Exchange Property Purchase

Next, you can proceed to pay for the new property. Note that the asset must have an equal or greater market value than the one it’s about to replace in the exchange. You can either fund the purchase using cash or a mortgage financier. 

  • Exchange Property Title Transfer

Once the replacement property purchase is complete, you must turn over possession to the Exchange Accommodation Titleholder, as stipulated in the QEAA you both signed. 

  • Identifying Legacy Property for Sale

The next step for the investor is identifying one or more of their properties to sell against the replacement one. You must have found an investment property to sell within 45 days before closing the purchase on the new one. Also, you can pick multiple legacy properties, provided that they don’t have a higher market value than the replacement property.

  • Legacy Property Sale

The investor would have to find a buyer for the old investment property. Note that the EAT would get listed as the property seller since they’re legally the titleholders at that point. Typically, you must close the sales in 180 days to qualify for tax deference on the replacement property.

Wrapping Up

Income and capital gains tax are significant deductions to note if you’re into real estate investment. You might wonder, “what is a reverse 1031 exchange then?” 

It’s worth mentioning that you look out for certain risks to the exchange process. Asset value depreciation and unforeseen financial loss could negatively affect a reverse 1031 exchange. Therefore, it’s best to consult a real estate agent before making any commitments.

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