A 1031 exchange allows the taxpayer to defer federal and state capital gains and depreciation recapture when selling and replacing real and personal property held in a business or for investment. Deferring the gain represents additional working capital or an indefinite interest free loan to acquire the replacement property, totaling as high as forty percent of the relinquished or old property sales price. There are many types of exchanges that fit the transaction sequence, including forward, reverse, improvement and leasehold.
Reverse 1031 Exchange
In a reverse 1031 exchange, the replacement property is acquired before the relinquished property closes. The risk is that the relinquished property does not close within 180 calendar days or at all; consequently, the reverse exchange fails and the taxpayer owns two properties. The Seller may need to close before the taxpayer’s old property closes. The taxpayer may see an undervalued property that needs to be taken off the market quickly by entering into a Purchase and Sale Agreement and closing.
The first step is to visit with your CPA to determine the tax consequences of selling the relinquished property. Is there adequate recognized gain or tax due to warrant a 1031 exchange? Are there offsetting losses that minimize the tax due? Once the tax is known, the value of the 1031 exchange is the tax deferred.
Parking the Property
In a reverse 1031 exchange, the taxpayer is not allowed to own both the relinquished and the replacement property at the same time. The Internal Revenue Service created the term Exchange Accommodator Titleholder or EAT as the entity that parks or takes title to either the relinquished or the replacement. The EAT is typically a single member limited liability company (SMLLC). The cost of a SMLLC varies from state to state. California Department of Corporations requires the SMLLC to be registered in the state to park California properties which is an additional $800 expense plus the cost of establishing.
Determining which property to park or title to, is a based upon a number of factors including whether there is debt on the replacement or old property. Typically, Atlas 1031 Exchange, LLC will park the relinquished property allowing the taxpayer to acquire the replacement property as normal. If the replacement property is parked and there is a loan, then Atlas 1031 Exchange, LLC will sign a non-recourse note with the lender. Be sure to alert your lender before the loan goes to committee that subject property is being parked with a limited liability company. If parking the relinquished property, the loan payments by the taxpayer continue as normal to the lender.
Transfer Taxes
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.
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
Making the decision whether to initiate a reverse 1031 exchange takes time to understand the variables, starting with a visit with your CPA. The next step is engaging a Qualified Intermediary to understand the steps. If you have a question regarding a reverse or forward 1031 exchange, contact our office or click on the button below to ask a question.
