Your Guide to the Reverse 1031 Exchange
Real estate investors have a number of tools to take quick advantage of opportunities. One such strategy, the reverse 1031 exchange, switches up the order of the traditional 1031 exchange method so you can buy a new property before you sell — and exchange — the existing asset. Not only does the reverse 1031 allow you to act immediately on an attractive deal, but it also lets you time the sale of your existing property to optimize potential profit.
While the reverse 1031 exchange can be more complex and more costly, it can also open an avenue to a profitable deal. Below are the details you need to understand if you’re considering this type of transaction.
The Reverse 1031 Process
You can use the reverse 1031 exchange to purchase investment properties such as commercial buildings, multifamily units, warehouses, vacant land, and rental houses, but not primary residences or second homes. Similar to a standard 1031 exchange, the properties are required to be of “like kind,” which means both properties must be used in a business or for investment, not that they must be the same type of real estate. You can still exchange an office building for another office building or for a different type of investment property such as a hotel, a rental residential property, raw land, a shopping center, etc.
You’ll need a special type of short-term financing for a reverse 1031 exchange. Only certain lenders and banks offer this service, which must also involve a qualified intermediary (QI). If you have the funds available, you can also use cash to purchase the property.
The new property will need to purchased in the name of your QI. That entity will hold the title on the property until you sell your existing investment, which must have a value equal to or less than the purchase price of the new asset. Otherwise, you must pay taxes on the profit you make on the sale of the original property.
After closing on the new property, within 45 days, you must identify one or more currently owned investment properties to be exchanged for the new replacement property. A reverse 1031 exchange is still subject to the same identification rules as a traditional 1031 exchange, such as “the three property rule” and “the 200 percent rule”. Additionally, to successfully complete the reverse 1031 transaction, the identified property must be sold within 180 days of the acquisition and the replacement property transferred from the QI to the investor.
While a reverse 1031 has its benefits, it isn’t for everyone. Keep these considerations in mind:
- This technique can only be used to buy an investment property; if used to purchase a home, you cannot live in it as a primary residence until at least two years after the sale.
- The fees associated with a reverse 1031 exchange can quickly add up and may exceed $10,000 compared to $1,500 for the typical 1031 exchange. These costs do not include the high financing cost of a short-term loan.
- Sellers may be unfamiliar with this strategy and pause to accept your offer in a competitive real estate market. It’s important to work with an agent who can thoroughly explain this aspect of the transaction and remove possible doubts. Having bridge financing lined up in advance can improve your chances of a successful bid.
- If you don’t sell your original property in the 180-day timeframe, you will either own both properties or lose your claim to the new property along with the earnest money (if the purchase hasn’t closed yet). While many markets are currently competitive, climbing mortgage rates could slow down sales, jeopardizing your 180-day limit for a reverse 1031 exchange. Your agent should keep this aspect of the transaction confidential, as prospective buyers would use this information to their advantage.
- You must be able to demonstrate that you have the financial means to purchase the new property. In other words, you must have either cash or a mortgage to complete the transaction even if the reverse 1031 exchange does not work out as expected.
Brighton Jones has the necessary experience with 1031 exchanges and reverse 1031 exchanges to protect your investment opportunity and your financial interests. Our team will help you establish a state LLC to hold title to the new property until you sell your existing asset and include the necessary non-recourse language. We’ll also handle the escrow, title, and transfer tax to ensure that both transactions go smoothly, a process that should start at least three weeks before closing on your purchase. Connect with an advisor today to strategize about next steps to meet your real estate investment objectives.