Inside the Mechanics of Reverse 1031 Exchange

Introduction

In a reverse 1031 exchange, also known as a “parking arrangement,” a property owner acquires a replacement property before selling their relinquished property. This is the opposite of a traditional 1031 exchange where the relinquished property is sold first, and then a replacement property is acquired.

In a reverse 1031 exchange, an Exchange Accommodation Titleholder (EAT), a third-party entity, holds legal title to either the replacement property or the relinquished property, or both, during the exchange period. The use of an EAT in a reverse 1031 exchange is crucial for complying with the regulations outlined in Section 1031 of the Internal Revenue Code, which allows for the deferral of capital gains tax on the sale of property if certain conditions are met.

Mechanics of the Reverse 1031 Exchange

A property owner identifies a replacement property that they want to acquire, even before selling their existing property.  The property owner engages an EAT to facilitate the exchange. The EAT acquires legal title to either the replacement property or the relinquished property. The property owner transfers funds to the EAT to purchase the property.

The property owner sells the relinquished property to a buyer.  The EAT acquires the relinquished property from the property owner.  Once the relinquished property is sold, the EAT transfers the replacement property to the property owner. 

By using the EAT, the property owner ensures that the exchange complies with the 1031 exchange regulations. The capital gains tax on the sale of the relinquished property is deferred because the proceeds from the sale never touch the property owner’s hands directly. Instead, the funds are held and managed by the EAT until the exchange is completed.

Benefits of the Reverse Starker 1031 Exchange

If the taxpayer cannot extend the closing of the replacement property and wishes to secure it promptly, a reverse exchange offers a viable solution. This approach enables the taxpayer to acquire the replacement property first, ensuring its acquisition, and subsequently transfer the relinquished property.

Moreover, if the taxpayer faces a scenario where the closing on the relinquished property falls through or experiences delays, and they are already committed to purchasing the replacement property, a reverse exchange becomes essential. In such cases, if extending the closing of the replacement property is not possible, completing the closing on the replacement property first becomes imperative, facilitated by a reverse exchange.

Additionally, when a property is intended for business use, a reverse exchange proves invaluable in minimizing business disruption. This reverse exchange allows the business to acquire the new space, transition all assets and employees seamlessly, and operate from the new location before closing the sale of the old space. Essentially, this enables the business to access both spaces concurrently, streamlining the relocation process.

Conclusion

The reverse 1031 Exchange is a powerful tool that opens up new possibilities for real estate investors seeking to defer capital gains taxes and optimize their investment strategies. By reversing the order of property transactions, investors can take advantage of enhanced flexibility and diversification opportunities, ultimately strengthening their overall financial position. 

Reverse 1031 Exchanges offer strategic advantages to investors, enabling enhanced flexibility, versatility, and tax deferral potential. Learn how you can positively transform your investment journey

Voss Real Estate Advisors

November 11, 2023

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