Why Your Next 1031 Exchange Should be a Reverse Exchange

The majority of all 1031 exchanges are structured as either forward delayed exchanges or simultaneous exchanges. This is likely because of the perceived ease in completing such exchanges. But failing to consider a reverse exchange could be costing many taxpayers more than they think. Let’s compare the exchange strategies of two siblings, Jean, and her brother Jeremy.

Forward Exchange

Jeremy is certain that a forward delayed exchange is the best way to handle the exchange of his investment property. His current property – which we will call Strawberry Field – is worth around $400,000 and yields about $3,000 in monthly rental income.

On March, Jeremy enters into a contract to sell Strawberry Field for $400,000, with closing scheduled for April 1. Closing occurs without delay, after which the $400,000 in exchange proceeds are wired to his qualified intermediary (“QI”). The QI is paid $1,000 for its services, leaving Jeremy with $399,000 to reinvest. Jeremy promptly starts looking for appropriate replacement properties. He is targeting single-family or condo-style properties near the local university. On May 15, Jeremy submits his identification list, designating three potential replacement condos, each worth $200,000. By the end of the month, Jeremy has been able to negotiate contracts for the purchase of two of the condos. Closings for the condos are scheduled for July 31. As a result of some title-related delays, Jeremy is able to complete the acquisition of the two condos on August 31, 152 days, or a full five months after he sold Strawberry Field. Jeremy has lost five months of rental income, $15,000, and paid $1,000 to his qualified intermediary, for a “loss” of $16,000.

Reverse Exchange

Jean was always the more analytical of the siblings. She consulted her QI months before she began the process of upgrading her investment situation, and has determined that a reverse exchange better suits her needs. A reverse exchange is one that takes place in a reverse sequence, that is, the replacement property is effectively acquired before the old property is sold. While a taxpayer is not allowed to directly acquire the new property first, a reverse exchange structure using an exchange company can accomplish the same thing. Jean’s current investment property – which we will call Solsbury Hill – is worth around $400,000 and yields about $3,000 in monthly rental income.

On February 1, Jean enters into a contract to acquire Paisley Park, a fully occupied rental property, for $400,000. Closing is scheduled for April 1. Jean coordinates with her QI to structure this acquisition as the replacement property for a reverse exchange. Accordingly, with the QI’s aid, she forms a new LLC – Paisley Park LLC – to take title to Paisley Park. Formation of the LLC cost her about $500 including the legal fees, and the QI’s related exchange accommodation titleholder (“EAT”) was listed as the sole member of the entity. On April 1, Paisley Park LLC acquires Paisley Park, which is generating approximately $3,000 per month. Allowing the EAT to take title on her behalf, she is not considered to have acquired it herself but has taken it off the market and preserved her ability to use it as her replacement property once the relinquished property is sold.

Jean enlists the aid of her friendly real estate agent and begins marketing the sale of Solsbury Hill. Jean and her real estate agent successfully negotiate the sale of Solsbury Hill, and on June 1 she enters into a contract to sell the property for $400,000, with closing scheduled for August 1. As a result of some financing related delays, Jean’s buyer is finally able to complete the acquisition of Solsbury Hill on August 31. This is closed as the first leg of a routine forward exchange using the QI. Once closed, Jean is ready to finish her exchange. At this time, the EAT transfers membership of Paisley Park LLC to Jean, officially cementing Jean as the owner of Paisley Park. From the time Jean acquired Paisley Park until she disposed of Solsbury Hill was five calendar months. During this time, she had combined cash flow on the two properties of $30,000. She did have to pay $500 for the formation of the LLC, and her exchange fees were about $4,000, so she had net income of $25,500 during the same time when Jeremy had net losses of $16,000 – a difference of over $41,000.

The Bottom Line

For exchangers who have the financial capacity to do so, structuring transactions as reverse exchanges is an option that is often overlooked. Among other things, it takes away the pressure of having to narrow down choices of possible replacement property within 45 days of a sale of the original property. Consulting with a QI, as well as tax and legal advisors before embarking on the sale of investment real estate is highly recommended. The skilled and experienced team at Accruit can help structure forward and reverse exchanges, and even non-safe harbor reverse exchanges that may take longer than 180 days to complete.