Most individuals that are familiar with 1031 exchange know of the standard forward exchange where a relinquished property is sold first and then a replacement property is acquired second. More savvy investors are starting to ask, “What is a reverse 1031 exchange?”
A reverse 1031 exchange represents a tax deferment strategy when, for a variety of reasons, the replacement property must be purchased before the relinquished or old property is sold. It is more complex than a forward 1031 exchange and requires careful planning, however the timeline of a reverse exchange follows standard 1031 exchange rules.
How Much Does a Reverse 1031 Exchange Cost?
The cost of a reverse 1031 exchange is generally much higher than a forward exchange because of the complexity and standard state fees associated with such exchanges. Although fees vary from state to state, you can expect the reverse exchange fee to range between $6,000 and $10,000.
The total cost of the reverse exchange can also be influenced by the number of properties involved. If multiple properties are being sold and acquired, the cost for each additional property can range between $400 and $600. While the cost of a reverse 1031 exchange may be higher than expected, keep in mind that a lot of the fees are standardized by state, and you’ll have peace of mind in securing your ideal property first.
Steps of a Reverse 1031 Exchange
Step 1: Engage a Qualified Intermediary to create an Exchange Accommodator Titleholder Agreement.
In this step, the Exchangor engages Atlas 1031 Exchange to create an Exchange Accommodator Titleholder (EAT) once it is determined that a reverse exchange makes sense to park or take title to either the new or the old property.
In a reverse 1031 exchange, the Exchangor cannot hold title to both properties at the same time, so an Exchange Accommodator Titleholder (EAT) is created to take title or park either the old or new property. The EAT is a single member limited liability company (SMLLC) created for the purpose of holding the property for the duration of the 1031 reverse exchange. The SMLLC is never reused or simultaneously holding property for another exchange. Once the old property sells, the equity is returned to the Exchangor for the cash contribution to the new property or to pay down the new property debt. EATs are also used while the new property receives improvements.
If the decision is to park the old property with the EAT, then a warranty deed is prepared by the escrow company, transferring ownership of the old property from the Exchangor to the EAT. The deed is recorded prior to the replacement property recording. While the old property is parked, the Exchangor is responsible for loan payments, insurance, taxes and operating expenses through a triple net lease agreement. All rent flows to the Exchangor and mortgage payments made to the lender as normal.
Deciding which property to park is dependent on a number of factors:
- Is the new property being acquired with a loan? If so, has the loan already been approved? If not, given the EAT may be on title, will the lender allow for the EAT—a SMLLC with the single member being a company owned by the member who also owns Atlas 1031 Exchange, LLC (the Qualified Intermediary)—to hold title? If so, can the note be non-recourse to the SMLLC?
- Does the state where the property is parked have a transfer tax on the conveyance of the title? If so, does the state recognize the EAT’s role as an agent of the taxpayer in the 1031 reverse exchange, effectively waiving the tax? The Florida Department of Revenue recognizes the EAT’s role and has a transfer tax and a statute waiving the tax in a 1031 reverse exchange.
- If there is a loan on the old property and it is parked with the EAT, will the transfer of title trigger a due on sale clause? If so, will the lender understand and provide the grace to complete the 1031 exchange?
In a reverse last, the new property is parked with the EAT. Improvements can be made to the property and paid with funds provided by the taxpayer. The acquisition funds are reimbursed once the old property sells. The old property is listed for sale and must be sold by the 180th calendar day post-closing on the new property. Exchange funds are wired to the taxpayer. If the old property does not sell, the exchange fails and the title for the new property is conveyed to the taxpayer.
Step 2: The Exchangor enters into a Purchase and Sales Agreement with the Seller.
The Exchangor enters into a Purchase and Sales Agreement (PSA) for the replacement property with the Seller. Included in the PSA is the 1031 assignment language.
Step 3: The Qualified Intermediary prepares all documentation for closing.
Atlas 1031 prepares multiple 1031 exchange agreements, including the Qualified Exchange Accommodation Agreement, Promissory Note, Pledge of Membership Interest and Lease for the first leg closing. The Exchangor secures any necessary financing for the purchase through a primary, bridge or equity loan.
Step 4: Identify the property that will be sold.
If the old property is parked, no identification is needed of the replacement property. If the new property is parked, then the old property is identified as the property to be sold.
The next step is identifying and finally selling the old property. The taxpayer has 45 days from the purchase date to identify or change the property that he/she plans to sell to complete the exchange and 180 days from the date of the purchase to actually complete the transaction. Upon the sale of the old property, the net equity goes to pay off the taxpayer’s loan on the replacement property—if one exists—or to reimburse the taxpayer. It is at this point that the QI will transfer the ownership (transfer of the deed or transfer ownership rights of the EAT to the taxpayer) of the new property to the taxpayer to complete the reverse 1031 exchange.
Step 5: The Exchangor enters into PSA with Buyer of Old Property.
The Exchangor enters into a PSA with the Buyer of the old or relinquished property that includes the 1031 assignment language.
Step 6: Final closing documents and agreements are signed.
At the closings, traditional closing and exchange agreements are signed. If the old property is parked with the EAT, the EAT signs as the Seller for the benefit of the Exchangor, while the taxpayer signs the settlement statement under Read and Approved. Proceeds from the old property sale are reimbursed to the Exchangor or wired to the replacement property lender to pay down the note.
If the new property is parked with the EAT, the EAT signs as the Buyer for the benefit of the Exchangor while the Exchangor signs under Read and Approved. Once the old property sells, the EAT conveys the replacement property title to the Exchangor no later than the 185th day post the first leg closing.
Reverse 1031 Exchange Rules
1031 rules and requirements for reverse exchanges are the same rules followed for forward 1031 exchanges when the old property is closed before the replacement is acquired and closed.
- Reverse exchanges must be completed within 180 calendar days of the initial closing
- The taxpayer buying must be the same as the taxpayer selling
- Related party and disqualified person rules apply
- The replacement property must be of equal or greater value than the relinquished property; otherwise, a tax is triggered on the difference
- Neither the relinquished or replacement properties can be the primary residence of the taxpayer
Potential Challenges of a Reverse 1031 Exchange
One of the challenges in a tight credit market is securing a loan. Those with cash or access to cash are able to move quickly without lender restraints. The downside of a 1031 reverse exchange is that if the old asset does not sell within 180 calendar days, two assets are owned.
Transfer tax may be due when changing title or conveying title to the EAT and out of the EAT. Some states recognize the EAT’s role as an agent of the taxpayer and do not assess a tax. Often an assignment of membership interest in the EAT to the taxpayer makes sense when the replacement property is parked with the EAT and later conveyed to the taxpayer to potentially avoid a transfer tax. Every state is different and the Qualified Intermediary will need to understand and advise the taxpayer.
Contact us
A reverse 1031 exchange can be complex and requires the oversight of a knowledgeable Qualified Intermediary. Contact us through our consultation form below or call our office at 1-800-227-1031 to ask any questions you may have. We look forward to hearing from you and helping you with your reverse 1031 exchange.
