How does a reverse 1031 exchange work?

If an opportunity comes your way to buy property, but you haven't sold yours yet, a reverse 1031 exchange may be the best resolution for tax planning purposes. In a regular 1031 exchange, you can exchange the property you own for another property, and defer taxes on the gains. When you end up buying another property first, the 1031 is reversed. If you follow the rules, you can still enjoy tax benefits.

How it Works in General

When you find a property and want to exchange with your old property for tax purposes, you can use the reverse 1031 exchange rules. When you buy the new property, you transfer legal title to it and “park it” until you're able to sell your old property. Once you sell the old property, you can regain title to the new property and defer any taxes on the gains acquired by the sale.

Safe Harbor Rule

IRS revenue procedures explain the "parking" guidelines relating to a reverse 1031 exchange. You cannot just own the replacement property outright if you want it to qualify as an exchange. You have to "park it" first, until you're able to sell the property you want to relinquish. In order to accomplish this, you must establish an Exchange Accommodation Titleholder (EAT) to hold legal title to the replacement property for your benefit while you facilitate a reverse 1031 exchange. The EAT has to convey title back to you no later than 180 days after acquiring it. You will be required to manage and care for the property, even though the EAT owns the title. Also, if it is a rental or other investment property, you are entitled to the net profits during the holding period.

Non-Safe Harbor Rule

There are times when you cannot meet the 180 days deadline requirement. For example, if you are unable to sell your old property, either due to slow housing sales or other issues, then you may need more time. You are allowed to go beyond the 180 day requirement to complete the exchange in some cases. Those situations are referred to as as a non-safe harbor exchange.

No Identification Period

The 1031 exchange rules require you to identify a replacement property no later than 45 days after selling the relinquished property, which is the property you owned and sold. You don't have that time limitation with a reverse 1031 exchange. You can take all the time you need to find the right replacement property, and in some markets, you'll need all the time that you can get. Once you purchase a replacement property, the 45 day rules will take effect again, requiring you to identify the property you want to relinquish.

A reverse 1031 exchange may be best solution during a recession and when real estate sales go downhill. It buys you the time you need to find new property at the best price and allows you to receive your tax benefits.

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