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Reverse 1031 Exchange Rules for Real Estate Investors

May 20, 2024

A reverse 1031 exchange follows the opposite sequence of a traditional 1031 exchange. The differences in the exchange processes also mean that there are some additional rules and requirements for a reverse exchange. As a real estate investor, you need to understand and adhere to these rules to successfully defer capital gains taxes through a reverse 1031 exchange.

At Universal Pacific 1031 Exchange, we understand how reverse 1031 exchanges work and can guide you through the rules for a successful tax-deferred exchange. With over 30 years of experience, we can help you maximize the tax benefits of the reverse exchange while staying compliant throughout the process. Book a free consultation with us today to get started.

In this blog, you’ll learn about the different rules and requirements for a successful reverse 1031 exchange as well as potential pitfalls to avoid.

What Is a Reverse 1031 Exchange?

What Is a Reverse 1031 Exchange?

A reverse 1031 exchange is a type of 1031 exchange that allows you to purchase the replacement property before selling the relinquished property. Unlike the traditional 1031 exchange which requires that you first sell the relinquished property before acquiring the new property, a reverse 1031 exchange requires that you acquire the new property and hold it by an Exchange Accommodation Titleholder (EAT) until you can sell the old property within the required timeframe.

Rules Guiding the Reverse 1031 Exchanges in California

The Internal Revenue Service (IRS) regulates reverse 1031 exchanges in California, under Section 1031 of the Internal Revenue Code (IRC). Reverse exchanges follow the same general tax-deferral rules that govern traditional 1031 exchanges, except that you’re able to acquire the replacement property before selling the relinquished property. For instance, the 180-day IRS timeline still holds, meaning that you have to complete all the reverse exchange transactions within 180 days. You must also reinvest the entire proceeds from the relinquished property sale into the purchase of the replacement property. Additionally, the replacement property must have equal or greater value than the relinquished property.

However, there are some additional requirements for reverse 1031 exchanges in California. An example is the claw-back provision. Under the claw-back rule, you must pay the deferred capital gains tax to California when you eventually sell the replacement property even if the replacement property is out of state.

To give an example, assume you sell an investment property in California and reinvest the proceeds in a replacement property in another state, say Alaska, via a reverse 1031 exchange. The claw-back provision requires that when you eventually sell the replacement property in Alaska, you’ll have to pay the deferred capital gains tax in California. Note that you may also owe taxes on the gain in the state where the sold replacement property is located.

Moreover, if your reverse exchange involves out-of-state investment properties, you must report the exchange to the California Franchise Tax Board (FTB) by filing Form 3840. The FTB uses Form 3840 to track gains deferred through 1031 exchanges so that they can enforce the claw-back provision when the replacement property is eventually sold. You’re required to file the FTB 3840 in the year of the exchange. You must also continue to file the form with the FTB under the following conditions:

  • You must file the form as long as you defer capital gains tax.
  • You must file the form if you relinquish the out-of-state replacement property to acquire another out-of-state property in a different 1031 exchange.
  • You must continue to file the form until you pay the deferred tax to California and report accordingly.
  • You must continue filing the form till the owner of the replacement property dies. Such demise will eliminate the deferred gain or loss.
  • You must continue filing the form unless you donate the replacement property to a non-profit organization (NGO).

If you fail to file Form 3840, your tax return may attract severe legal consequences. For example, the FTB may issue a Notice of Proposed Assessment to revise your income to include the gains that you previously deferred through a 1031 exchange. Hence, all your capital gains that were initially tax-deferred due to the 1031 exchange will then be considered taxable income for the year in which the FTB issues the NPA, meaning more tax burden for you in that year. Apart from reversing the tax deferral benefits, failure to report your tax return or file the required form may attract other penalties from the FTB, such as interest on the unpaid taxes, calculated from the original due date of the tax payment to the date when the payment is made.

Considering all these, it’s important that you consult with a tax advisor or an experienced qualified intermediary in California to ascertain that you adhere to all the rules and legal requirements for a reverse 1031 exchange. Additionally, you should pay extra attention if your reverse exchange involves a replacement property located outside California.

Key Differences Between Traditional and Reverse 1031 Exchanges

Key Differences Between Traditional and Reverse 1031 Exchanges

Although the traditional and reverse 1031 exchanges are both good ways to defer capital gains taxes, there are significant differences in their processes and requirements. These differences affect important factors such as the timeline and financial demand of the entire exchange process. Hence, as a real estate investor, you need to understand these differences so you can choose the pattern that is most suitable for your investment strategy.

The most notable difference between traditional and reverse 1031 exchanges is the order of transactions. In a traditional 1031 exchange, you sell the relinquished property first, identify potential replacement properties, and then reinvest the sale proceeds into the replacement property. The opposite is the case for reverse exchanges. First, you acquire the new investment property and hold it through a qualified exchange accommodation arrangement. Then you sell the relinquished property while making sure all transactions are completed within the IRS timeline.

Another major difference is the complexity and cost of the exchange. Traditional exchanges are usually less costly and more straightforward. You sell the old property, identify the new property, and complete the purchase using the proceeds from the sale. Contrarily, reverse exchanges involve more complex processes and are generally more expensive. For example, you need an Exchange Accommodation Titleholder (EAT) to hold the title to the acquired property pending when you sell the relinquished property. This arrangement involves higher logistical, financing, and potentially legal costs.

In terms of financing, it’s more straightforward to finance a traditional 1031 exchange than a reverse exchange. For traditional exchanges, the funds from the sale of the relinquished property make acquiring the replacement property financially relatively stress-free. On the other hand, you may need to seek external funding to acquire the replacement property before selling the relinquished property since the sales proceeds wouldn’t be available yet.

Furthermore, the total timeline for 1031 exchanges is the same – 180 days – for both the traditional and reverse exchange processes. However, the processes for both methods differ during this 180-day timeline. For a traditional exchange, you must identify a potential replacement property within 45 days after selling the relinquished property. Then, you have the remaining 135 days from that point to close the new property. In contrast, for a reverse exchange, you have to identify the property you plan to sell within 45 days after the purchase of the new property.

Comparing risks, traditional 1031 exchanges are generally exposed to fewer risks than reverse 1031 exchanges. Selling the relinquished property first makes funds available for purchasing the new property, reducing the risks of failed transactions and possible tax consequences. Contrarily, it may be challenging to have enough funds to purchase the replacement property since the sales proceeds of the relinquished property wouldn’t be available yet. In addition, you may lose the tax benefits of the reverse exchange if you’re not able to sell the relinquished property within the specified timeframe.

The Benefits of 1031 Reverse Exchange

The Benefits of 1031 Reverse Exchange

From flexibility and financial planning to maximizing market timing advantages, there are many benefits that come with a well-planned reverse exchange. Let’s consider some of these benefits below.

  1. You can secure a desirable property as soon as it hits the market without waiting to sell yours first. This is a good way to avoid missing profitable investment opportunities.
  2. By purchasing the replacement property first, you can avoid the pressure of selling quickly under potentially unfavorable terms. That way, you have some more time to bargain for the right sale price.
  3. You can budget more properly when you know the price of the replacement property upfront. This will help you take proactive actions such as seeking external financing.
  4. Just like a traditional exchange, reverse 1031 exchanges primarily help to defer capital gains taxes. The tax savings can accumulate to increase your capital for more profitable investments. You only need to be sure that you adhere to the rules guiding a 1031 exchange and make sure to involve only the types of properties that benefit from a 1031 exchange.

How Much Does Reverse 1031 Exchange Cost?

Due to more complexity and additional processes, reverse 1031 exchanges usually cost more than traditional 1031 exchanges. However, the actual cost difference will depend on factors such as the value of the properties involved, the duration the EAT holds the relinquished or replacement property, financing terms, and the complexity of the transactions.

In terms of Qualified Intermediary (QI) fees, a traditional 1031 exchange costs between $500 to $1,500. On the contrary, a reverse 1031 exchange cost may get as high as between $4,000 to $6,500 in QI fees, depending on the qualified exchange accommodation agreement.

Comparing transactional and holding costs, traditional exchanges usually cost less as the QI simply holds the funds between the sale and purchase transactions. On the flip side, a reverse exchange may incur additional costs, especially if the EAT holds the property for a significant period. Such additional costs may include taxes, insurance, maintenance, and management fees. Typically, none of these costs are incurred in a traditional exchange.

Moreover, traditional 1031 exchanges do not incur any special financing costs as you basically use the relinquished property sale proceeds to purchase the new property. But for a reverse exchange, you may need to obtain funding using other lines of credit, which may attract extra costs in interest rates and fees.

In addition, you’ll likely require legal and tax advice to smoothly execute both traditional and reverse exchange. However, the legal and tax consultation fees may be higher for a reverse exchange because it is more complex, and, as such, you’ll need more specialized advice to help you stay compliant throughout the process.

Eligibility and Requirements for 1031 Reverse Exchange

Eligibility and Requirements for 1031 Reverse Exchange

A valid reverse 1031 exchange must meet certain requirements to qualify for capital gains tax deferral. First, the relinquished and replacement property must be like-kind, meaning that both properties must be held for trade, business, or investment use. The properties do not necessarily have to be the same type as long as they’re like-kind. For example, you can exchange raw land for an office complex.

Based on the property use criteria, properties held primarily for personal use, such as vacation homes or primary residences, do not qualify. However, you can live in a 1031 exchange property if you understand and comply with the IRS rules for personal property conversion. Note that both the relinquished and replacement properties must be located in the United States to qualify for a domestic 1031 exchange.

After acquiring the new property, you must hold it through an EAT following the safe harbor rule. You must also make sure you transfer the property to the EAT within 5 business days after acquiring the property.

Qualifications Needed From Real Estate Investors

Only “investors” (people who hold properties for investment purposes) qualify for reverse 1031 exchanges. Real estate dealers who hold properties primarily for resale do not qualify. Additionally, investors must have enough capital or means of funding to acquire the replacement property since the sale proceeds of the old property would not be available from the beginning.

Tax Implications for a Reverse 1031 Exchange

The primary tax benefit of a reverse 1031 exchange is deferring capital gains tax when you sell an investment property. This reduces your taxable income for that year, and the tax savings can accumulate to increase your available investment capital. Make sure to stick to the 180-day exchange deadline if you want to defer taxes. If you miss this timeline or don’t meet all the requirements, you might lose the tax deferral benefit and have to pay taxes right away.

If the relinquished property was a depreciable asset, such as a rental building, part of the deferred gain might be subject to depreciation recapture when the property is eventually sold. Depreciation recapture is taxed at a higher rate than long-term capital gains. Therefore, you need to consider how much depreciation has been claimed to evaluate the potential future tax liability.

Note that in addition to federal taxes, you must also consider state taxes, especially if the properties involved are in different states. For example, California’s claw-back provision is a specific state rule that regulates how deferred gains are taxed when the replacement property is eventually sold.

Moreover, certain transaction costs and fees associated with the exchange can be treated as part of the exchange itself, meaning they won’t be immediately deductible as current business expenses. These include costs directly related to acquiring the replacement property, like finder’s fees or advisory fees that can be capitalized.

Step-by-Step Process of a Reverse 1031 Exchange

Step-by-Step Process of a Reverse 1031 Exchange

Since the reverse exchange processes differ from the traditional exchange process, it’s important to make sure that each step is executed correctly and according to the requirements. Below is a step-by-step breakdown to guide you.

  1. Start by engaging a Qualified Intermediary. An experienced QI such as Universal Pacific 1031 Exchange will be able to answer your questions regarding the legal complexities and processes and provide professional support throughout the process. You also need them to hold the title to the replacement property through an EAT. Take advantage of our free consultation to discuss your exchange needs.
  2. Identify the replacement property. Remember that you can exchange two properties for one as long as you follow the identification rules and other IRS requirements. Keep in mind that the total market value of the replacement properties must be equal to or greater than the value of the relinquished property.
  3. After identification, you can acquire the replacement property. Since the law does not allow investors to hold the relinquished and the replacement property at the same time, your QI holds the title to the property through an EAT.
  4. From the date of the purchase of the replacement property, you have only 45 days to identify and sell the old property. Hence, market and sell the relinquished property as fast as possible. To avoid boot in a 1031 exchange, make sure that all the sales proceeds from the sale are reinvested into the new property.
  5. After the sale of the relinquished property, ask the QI to transfer the title of the replacement property from the EAT to you. This step formally completes the reverse 1031 exchange process.
  6. Document every transaction, including the identification notices, the financing, and the roles of the QI and EAT. In addition, file the appropriate forms, such as Form 3840 if your replacement property is out of state.

Common Mistakes in Reverse 1031 Exchanges and How To Avoid Them

Common Mistakes in Reverse 1031 Exchanges and How To Avoid Them

Mistakes in the reverse exchange process can disqualify your exchange from tax deferral and may also result in other legal or tax penalties. To avoid these mistakes, you need to first identify them, and then take proactive steps such as good planning and engaging the professional services of an experienced QI.

One of the most common mistakes investors make in reverse 1031 exchanges is failing to structure the exchange correctly. This involves issues such as incorrect titling or handling of the relinquished property sale proceeds. To avoid this, work with an experienced QI who can make sure that the EAT is properly set up and that you’re not in constructive receipt of the funds at any point.

Secondly, many investors misinterpret the timeline for the exchange. Note that you have 45 days to identify the relinquished property, and 180 days to complete the whole exchange. Always communicate with your QI to be sure you’re on track to avoid missing deadlines.

Another common mistake is failure to prepare for the sale of the relinquished property ahead of time. Sometimes, investors assume that it’s always easy to sell their property. As a result, they may eventually exceed the timeline of the exchange if they encounter any challenges such as not having a ready buyer. To prevent this, plan the sale ahead of time to be sure there will be no delays that will extend beyond the given timeline.

Moreover, some investors also underestimate the reverse 1031 exchange costs. This may lead to inadequate financing which may in turn lead to delays in closing the deals. To avoid this mistake, make sure you consider other costs such as QI fees, financing costs, legal fees, etc.

In addition, poor documentation or record keeping can cause severe issues, especially in the case of an IRS audit on the exchange. As mentioned earlier, be sure to keep record of every process involved in the exchange, including the transactions, communications, contracts, EAT agreements, etc.

Need To Consult a Qualified Intermediary?

To successfully defer capital gains tax through a reverse exchange, you must understand the various rules that apply and comply with them throughout the process. Apart from general exchange rules such as the 180-day timeline and the replacement property identification rules, it’s important to pay close attention to tax filing and reporting, especially if your replacement property is located in another state. 

Failure to comply with any of these rules may disqualify you from the tax benefits of the exchange and even attract other legal consequences. Hence, it’s recommended to work with an experienced qualified intermediary with a track record of successful exchanges. As the best qualified intermediary in Los Angeles, Universal Pacific 1031 Exchange is committed to helping you facilitate a smooth exchange while adhering to all the applicable rules. Contact us today to start an exchange.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.