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Reverse 1031 Exchange As An Investment Option

by Rishav

Do you know that while executing a 1031 exchange, you can first acquire the replacement property and then close on the sale of the relinquished property? Well, it’s called a Reverse Exchange. A reverse exchange is also a kind of 1031 exchange. The only difference is that it’s entirely opposite to a normal 1031 exchange. Investors, pursuing reverse exchanges, need to acquire the replacement property before closing on the sale of the relinquished property. Similarly, there are some other kinds of 1031 exchanges that provide the benefits of tax deferment but are different from normal 1031 exchanges in one way or another.

Types of 1031 Exchanges

  1. Delayed Exchange – A delayed exchange is a typical 1031 exchange that allows investors to defer capital gains taxes on exchanging like-kind properties. The first step of a delayed exchange requires investors to sell the relinquished property. The Qualified Intermediary holds the proceeds of the relinquished property and reinvests it on the replacement property. As soon as you sell the old property and receive the proceeds, you get 45 days to identify a replacement asset.
  2. Simultaneous Exchange – Simultaneous exchanges aren’t any more popular among real estate investors. The reason is obvious. In a simultaneous exchange, an investor is required to sell the relinquished property and acquire the replacement property at the same time. Since investors need to acquire the replacement property the day relinquished property is sold, they barely get a minute of respite. 
  3. Improved or Built-to-suit Exchange – An improved exchange is a special kind of tax-deferred exchange that allows investors to carry out any kind of improvement work on the replacement property using the proceeds of the relinquished property. Another name for an improved exchange is ‘built-to-suit exchange.’ In an improved exchange, an investor can invest a portion of the proceeds on improving the replacement property. An improved exchange is possible in situations where the price of the replacement property is less than that of the relinquished property.

No matter how these forms of 1031 exchanges are different from each other, they provide the same benefits. Similarly, the role of a Qualified Intermediary also remains the same in all these exchanges. For better understanding, let’s see the role of a Qualified Intermediary in a reverse exchange. 

Role of a Qualified Intermediary in a Delayed Exchange

  • The Qualified Intermediaries represent investors in reverse exchanges. Since section 1031 reverse exchanges require investors to purchase the replacement property first, the Qualified Intermediary acquires the replacement property on behalf of the investors. 
  • Upon successfully acquiring the replacement property, the Qualified Intermediary looks for a buyer for the relinquished property. 
  • The Qualified Intermediary holds the title to the replacement property until the relinquished property is sold. Under no circumstances, an investor is allowed to hold the title of both properties (replacement and the relinquished one) together. 
  • After purchasing the new asset, the Qualified Intermediary transfers the replacement property title to the investor and completes the exchange.

It has become evident by now that Qualified Intermediaries play a vital role in 1031 exchanges irrespective of what kind of 1031 exchange it is. Though a reverse exchange also provides the benefit of tax deferment, it shouldn’t be your first choice. After all, investing in replacement property prior to the sale of the relinquished property may put investors in great financial risk. That’s why investors don’t often consider reverse exchanges as their first choice. Another risk associated with a reverse exchange is the possibility of not finding a potential buyer for your relinquished property within a limited time. Such risks aren’t rare in reverse exchanges. That’s why it’s better to go for a delayed exchange rather than opting for a reverse exchange.    

Your replacement property must fulfill the following requirements – 

  • Make sure that the Fair Market Value (FMV) of the replacement property is equal to or greater than that of your relinquished property. 
  • In case the fair market value of the replacement property is less than that of the relinquished property, then that will result in ‘Boot,’ and you will have to pay the taxes on the profit. A Boot can be defined as the ‘cash or profit received by the investor’ in the exchange. Boot eliminates the opportunity of tax deferment.
  • Another thing that you should take into account is the running debt on the replacement property. You must acquire a replacement property that has the same debt as your relinquished property.
  • The location of your replacement property also plays a vital role. As using a 1031 Exchange, you can acquire a replacement property anywhere in the entire USA; you must look for properties that are built-in developed localities as it will increase the cash flow.

Apart from these, you should also pay attention to things like the property’s age, mortgaged loan on the property, capitalization rate, etc. You should only initiate a 1031 Exchange once you have examined all these aspects.

So, what’s our role in your quest for a 1031 investment property? We make sure that a 1031 Exchange expert stays with you throughout a transaction. We also stay in touch with your attorney, accountant, or closing agent to ensure that the transaction carries out smoothly. 

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