Reverse 1031 Exchanges: The Benefits, Risks, and Tax Opportunities Real Estate Investors Need to Know
- May 1, 2023
Most real estate investors are familiar with a 1031 exchange, where a taxpayer may be able to defer the recognition of taxable gain on the sale of real property by acquiring replacement real property while meeting several requirements. 1031 exchanges generally follow the same order:
- Taxpayer sells property and utilizes qualified intermediary (“QI”) to receive and hold proceeds,
- Taxpayer identifies replacement property within a required timeframe, and
- Taxpayer acquires replacement property within a required time frame.
Taxpayers may experience timing pressures regarding standard 1031 exchanges because of the strict time limits on identifying and acquiring replacement property. An alternative to a standard forward 1031 exchange is the concept of a reverse 1031 exchange. In a reverse 1031 exchange, replacement property is acquired prior to the sale of the relinquished property.
There are tax deferral opportunities for real estate owners and investors in understanding the mechanics of a reverse 1031 exchange, the benefits, and risks of a reverse 1031 exchange, and finally collateral tax consequences of a reverse 1031 exchange.
How a Reverse 1031 Exchange Works
As mentioned previously, in a reverse 1031 exchange, replacement property is acquired prior to the sale of relinquished property. This contrasts with a forward 1031 exchange, where the relinquished property is first sold and after which a replacement property is identified and acquired. Like a forward 1031 exchange, for which there are significant timing and other qualitative and quantitative requirements that must be satisfied, a successful reverse 1031 exchange also depends on significant requirements being satisfied.
In most forward 1031 exchanges, taxpayers are not generally exchanging property directly for properties owned by other taxpayers. Rather, taxpayers utilize a QI which allows taxpayers to 1) sell a property to a third-party (i.e., Buyer “A”), 2) identify a new property within a stated timeline, and 3) acquire such new property from a different third-party (i.e., Seller “B”) within a stated timeline.
A similar concept exists for reverse 1031 exchanges since the taxpayer does not directly exchange property. In 2000, the IRS released Rev. Proc. 2000-37 (“Rev. Proc.”) which provided clarity to taxpayers regarding how a reverse 1031 exchange could be structured to be respected, including a safe harbor approach. Note that while the Rev. Proc. provides a safe harbor approach to accomplishing a reverse 1031 exchange, taxpayers may be able to achieve a reverse 1031 exchange using a non-safe harbor approach, which may provide more flexibility.
As discussed in the Rev. Proc., a reverse 1031 exchange under the safe harbor is accomplished using a Qualified Exchange Accommodation Arrangement (“QEAA”):
Two main methods of how a reverse 1031 exchange could be accomplished with a QEAA are:
- An Exchange Accommodation Titleholder (“EAT”) holds title to the replacement property.
- An EAT holds title to relinquished property.
When using option 1, some of the key steps are described in the following list:
- At the closing of a replacement property’s purchase, “qualified indicia of ownership” of the property is transferred to an EAT. A written QEAA is then executed at the same time or within five days of the transfer to the EAT. The QEAA provides that the EAT holds title to the property for purposes of a reverse 1031 exchange under the Rev. Proc., the EAT and taxpayer agree to report the acquisition, holding, and disposition of the property according to the Rev. Proc., and the EAT is treated as the beneficial owner of the property for all federal income tax purposes.
- After the initial closing, transfer of property to the EAT, and execution of a QEAA, the next step is that a taxpayer needs to identify the property to be sold (relinquished property) within 45 days of the initial closing. Note that the taxpayer has 45 days to identify the property it intends to sell. This contrasts with a forward 1031 exchange where the taxpayer has 45 days to identify a new property to acquire.
- Next, the relinquished property must be sold and transferred to a buyer within 180 days of the initial closing. Note that the taxpayer has 180 days to close on the sale of its property. This contrasts with a forward 1031 exchange where the taxpayer has 180 days to acquire new property. Generally, a QI is also utilized during this part of the transaction to effectuate the like-kind exchange component of the transaction.
Benefits of a Reverse 1031 Exchange
The benefits of a reverse 1031 exchange are generally a function of a taxpayer’s ability to close on replacement property without having to first sell a property.
A deal may come across a taxpayer’s desk which features favorable underwriting but requires a quick closing timeline. If the taxpayer was in the process of selling a property or considering a sale of property, such sale may not close prior to the purchase of the new property.
With the current real estate market being extremely competitive, a taxpayer’s request to delay a purchase may result in the loss of such transaction. A reverse 1031 exchange may be valuable here. With a reverse 1031 exchange, the taxpayer could confidently close on the purchase (through the safe harbor process of using a QEAA), and then work on the sale transaction within the required timeline.
Likewise, a taxpayer may be concerned about the 45-day timeline to identify new property for a forward 1031 exchange. With a reverse 1031 exchange, the 45-day timeline relates to the identification of property to be sold rather than the property to be acquired. Therefore, a taxpayer can casually underwrite the acquisition of various properties without being under pressure to commit to a property in 45 days.
Risks of a Reverse 1031 Exchange
The risks of a reverse 1031 exchange are generally a function of the required timeline surrounding the exchange as well as the financing component of a transaction.
A taxpayer must identify the property to be sold within 45 days of the original purchase closing, and further must sell the property within 180 days of the original purchase closing.
While the 45-day identification period may be easy to satisfy, 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, all within the specified timeline to have a successful exchange.
An additional consideration is financing the replacement property that is acquired at the beginning of the exchange. Since the EAT holds title to the property during the exchange (under Option 1 above), the EAT will be named the borrower on any loan. Taxpayers should plan accordingly and speak with lenders early on to ensure financing will be available.
Generally, these requirements may present risks and compromises that a taxpayer would need to accept if the exchange were to succeed.
Collateral Tax Consequences of a Reverse 1031 Exchange
Similar to a forward 1031 exchange, a successful reverse 1031 exchange allows a taxpayer to treat the sale of a property as a nonrecognition event and, therefore, generally not have to recognize taxable gain. However, as with forward 1031 exchanges, there are several ways that taxable gain could still be generated. For example, the receipt of cash or mortgage boot in an exchange could generate gain to a taxpayer. Furthermore, since nonrecognition treatment for 1031 exchanges now only applies to real property, gain may be generated if certain types of non-real property, such as personal property, is included in the exchange (note there are certain exceptions for incidental personal property).
The unique arrangement between a taxpayer and an EAT in a reverse 1031 exchange should also be considered when evaluating tax implications. While the EAT owns the replacement property, the taxpayer is not entitled to claim depreciation on such property because it is not deemed to own it for tax purposes. The property is leased by the EAT to the taxpayer during such time for the taxpayer to be able to operate the property, collect income, and pay expenses. Particularly where a reverse 1031 exchange occurs over a period that crosses two tax years, an analysis should be done regarding the type of income and expenses that will be reportable by a taxpayer for each such year.
Next Steps When Considering a Reverse 1031 Exchange
Both taxpayers contemplating the sale of a property as well as those considering an acquisition of a property should be considerate of the tax deferral opportunities under a reverse 1031 exchange. As discussed above, reverse 1031 exchanges, albeit different in mechanics from forward 1031 exchanges, still have specific requirements that need to be met for a valid exchange. Since there are multiple parties involved in any 1031 exchange including accountants, attorneys, and QIs, upfront and coordinated consultation with all advisors is recommended to achieve a successful exchange.
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Michael Torhan is a Tax Partner in the Real Estate Services Group. He provides tax compliance and consulting services to clients in the real estate, hospitality, and financial services sectors.
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