REVERSE 1031 EXCHANGE
A Reverse 1031 Exchange is like the Delayed Exchange explained in 1031 Exchange Rules, except that the Exchange is done in reverse.
You purchase the Replacement Property before you sell the Relinquished Property.
That’s why it’s called a Reverse Exchange.
If you need to review your familiarity with the Players and Terms of an Exchange before reading about the Reverse 1031 Exchange, you can do that on the Home page where we introduce you to all of the parties involved and explain the meaning of all of the words and terms.
If you need to review the steps of a standard real estate transaction, read Capital Gains Tax.
And if you need the definition of any of the terms, go to our Dictionary page.
If you’ve done that, let’s get started.
First, the problem.
The problem with a Reverse 1031 Exchange is that Section 1031 does not permit you to own both properties at the same time, and you would own both of them if you bought the Replacement Property before you sold the Relinquished Property.
So, the IRS has provided a way for you to do the Reverse 1031 Exchange, and the rules are laid out in Revenue Procedure 2000-37.
The rules require the use of what is called an Exchange Accommodation Titleholder, which is referred to as an EAT.
An EAT is a business entity, usually a Limited Liability Company, which is referred to an LLC.
The LLC is usually created and owned by the Qualified Intermediary (QI) involved in the Exchange.
A contract is signed between the Exchangor (you) and the EAT.
The contract is called a Qualified Exchange Accommodation Arrangement, which is referred to as a QEAA.
This entire situation does not have to be this complicated, and would not be if the government were not involved.
Buy they are, and it is.
To recap, the QI creates an EAT, which signs a QEAA with you, the Exchangor.
The EAT will also be involved in a Construction Exchange, discussed elsewhere, as well as this Reverse Exchange.
If you need definitions on any of these terms, please check out our Dictionary.
Now, we are ready to go with our Reverse 1031 Exchange. This would be a good time for you to check out my qualifications at About.
Now, back to our story.
The EAT can hold title to either the Relinquished Property until it is sold, or it can hold title to the Replacement Property until the Exchangor buys it, so that the Exchangor does not have to hold title to both at the same time.
The purpose of the QEAA is to set out in writing that a Reverse 1031 Exchange is being done and that the:
It's Like A Seminar In A Book
IF YOU USE A DELAWARE STATUTORY TRUST, TRIPLE NET LEASE, OR A T-I-C, YOU MUST HAVE THIS EDITION.
* Intent is to do a Section 1031 Exchange,
* EAT is acquiring and holding the property solely for the benefit of the Exchangor in order to meet the requirements of Section 1031,
* EAT will be considered the titleholder for income tax purposes, and
* EAT will file the necessary tax returns and information reports with the IRS.
You will not have to do this yourself, your QI will do it for a fee. But if you are interested, the Qualifications for an EAT are outlined in Treasury Regulation 1.1031(k)-1(k).
The Reverse 1031 Exchange can be handled in one of two ways:
1. The EAT can purchase the Relinquished Property from the Exchangor and sell it, an arrangement which we will call “Sell First,” or
2 The EAT can purchase the Replacement Property and hold it until the Exchangor has sold the Relinquished Property, and then sell the Replacement Property to the Exchangor, an arrangement that we call “Buy First.”
We will explain the procedure for each one.
SUMMARY: Whether the Exchangor chooses the “Buy First” or the “Sell First” he will have the same 3 problems with his Reverse 1031 Exchange:
- He cannot hold title to both pieces of property at the same time.
- He has not sold his Relinquished Property so he does not know the amount of net sales proceeds that he will have to invest in the Replacement Property, and therefore the amount of new financing.
- He does not yet have the money to purchase the Replacement Property because he has not sold the Relinquished Property.
There are ways to deal with all three problems.
In addition, he can avoid the double payment of Title Policy fees and the double payment of Real Estate Transfer fees.
READING TIME: Approximately 15 minutes.
SELL FIRST IN REVERSE 1031 EXCHANGE
First, a quick word.
If you are one of the victims of the rampant misinformation on the web that says you cannot sell your investment property if you were thinking certain thoughts when you bought it (I know, bizarre!), get the facts here about Intent.
Now, back to the Reverse Exchange.
In this Reverse 1031 Exchange scenario, the Exchangor has found Replacement Property that he feels that he must purchase immediately. He cannot wait until after he sells the Relinquished Property.
But he has three problems:
1.) He cannot hold title to both pieces of property at the same time, and
2.) He has not sold the Relinquished Property, so he does not know the amount of Net Sales Proceeds that he will have to reinvest in the Replacement Property, and he needs this information in order to determine how much his down payment will be, and he needs to know this in order to decide his note amount will be (whew!), and
3.) He does not yet have the money to purchase the Replacement Property because he has not received his money from the sale of the Relinquished Property.
We will use Alan Adams and his transaction as an Example in analyzing this Reverse 1031 Exchange. The facts are as follows:
:: Adams bought a Duplex ten years ago for $200,000 cash.
:: He assigned a value of $20,000 to the land, $180,000 to the building.
:: He began depreciating the building.
:: He spent $30,000 cash on two garages, began depreciating.
:: He spent $20,000 cash on furniture, began depreciating.
:: He has claimed $65,400 straight-line depreciation on the Duplex.
:: He has claimed $7,644 straight-line depreciation on the garages.
:: His total straight-line depreciation claimed is $73,044.
:: He has claimed $15,200 accelerated depreciation on the furniture.
:: His total overall depreciation claimed is $88,244.
:: His Basis in the property is $161,756 (200,000 plus 30,000 plus 20,000 minus 88,244).
:: Bob Baker has offered him $400,000 cash for the Duplex.
:: If he accepts, his Capital Gains will be $238,244 (400,000 Sales Price minus 161,756 depreciated basis.
:: $15,200 of the $238,244 will be Accelerated Depreciation Recapture, taxed at 39.6%, resulting in $6,019 taxes.
:: $73,044 of the $238,244 will be straight line Depreciation Recapture, taxed at 25%, resulting in $18,261 tax.
:: $150,000 of the $238,244 will be regular Capital Gains, taxed at 20%, resulting in $30,000 tax.
: His total tax liability will be $54,280 (6,019 plus 18,261 plus 30,000).
THE FIRST REVERSE 1031 EXCHANGE PROBLEM
The first problem that Adams has, that of not being able to hold title to both pieces of property at the same time, can be solved by transferring title to the Duplex, the property that will become his Relinquished Property, to the EAT.
Under the terms of the QEAA, this is not considered a sale by Adams, but he is considered to be just “parking” the Duplex out of his name.
So, for Reverse 1031 Exchange purposes, he no longer “owns” the property.
He can now proceed with the purchase of the Replacement Property.
It is critical that this procedure be done exactly right.
And it is critical that you understand that the IRS is holding you responsible for making sure that your Reverse 1031 Exchange is done exactly right. If it isn’t, your Section 1031 Exchange will be disallowed and you will be writing a check to the IRS for $54,280.
It does not matter that you could show the IRS that your Qualified Intermediary is responsible for screwing up the transfer.
The Qualified Intermediary is not your agent and he is not providing you legal advice, he is an independent third party.
The agreement that you signed with him acknowledges all of that.
This is between you and the IRS.
When the EAT takes title to the Duplex, the EAT will:
- assume any existing debt on the property, and
- sign a note for the remaining amount of the sales price, creating a second lien on the property, and
- the note will be made payable to the QI, not the Exchangor.
The first time period for the Reverse 1031 Exchange has started running.
This is the Reverse 1031 Exchange Timeline.
The EAT will have 180 days to transfer the Relinquished Property to a buyer.
If Adams already has a contract to sell the Duplex, he transfers that contract to the EAT.
If he does not already have a contract, he will have to find a buyer for the EAT to sign a contract with.
When the EAT does eventually sell the property:
- the note that the EAT assumed will be paid off,
- other debts and closing costs will be paid,
- the remaining funds will be used to pay the note that the EAT signed with the QI,
- the QI will release the lien securing the second note, and
- the QI will send the funds to Adams.
Now, remember, the EAT is just a “shell company.”
It has no office, no employees, etc., and the QI is the only member, the sole owner, and the manager.
And the QI is not willing to manage the property that the EAT just acquired, during the period of time before the property can be sold.
So the QEAA can provide that the EAT leases the property back to Adams so that he can continue managing it without interruption.
This is a fairly common practice in a Reverse 1031 Exchange.
So, even though he “sells” the property to the EAT, he doesn’t give up possession and nothing else changes.
He continues with his management activities and his efforts to find a buyer.
The EAT does nothing.
THE SECOND REVERSE 1031 EXCHANGE PROBLEM
The second problem of not knowing the exact amount of net sales proceeds that he will need to invest in the Replacement Property can be overcome by just making a good estimate.
Adams already has a contract for $400,000 and he can estimate his net sales proceeds.
But even if he did not have a contract, he could just pick three prices: high, low, and average. Then he could estimate his net sales proceeds based on these, because he knows all of the other numbers.
He would probably just pick the highest price and estimate the net sales proceeds based on that. If it comes in lower, he has not broken any rules.
THE THIRD REVERSE 1031 EXCHANGE PROBLEM
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The remainder of this content, plus additional content, is available in my book “How To Do A Section 1031 Like Kind Exchange: Simultaneous, Delayed, Reverse, Construction” available at Amazon.com/dp/B01MY433L6.
And if you are dealing with a Triple Net Lease, Delaware Statutory Trust, or a Tenancy-In-Common property, you need the OMNIBUS EDITION at Amazon.com/dp/B07BJLZNZN.
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