Successfully completing a 1031 exchange requires strict adherence to the timelines set forth by the IRS. Two of the most important time-based 1031 exchange rules are the 45-day rule and the 180-day rule, each of which places limits on the amount of time an investor has to identify one or more replacement properties and to complete the purchase of at least one of the identified properties.
Recently, more investors have been taking advantage of a “reverse” 1031 exchange, which allows them to acquire a replacement property prior to the sale of the relinquished property and hold (or “park”) the replacement property until they’ve completed the 1031 exchange.
Thanks to IRS guidance, it’s also possible to combine a reverse 1031 exchange with the more common forward delayed exchange. Not only can this help facilitate your investment goals but combining exchanges can also create two sequential 180-day exchange periods, potentially giving you 360 days to successfully complete your 1031 exchange transaction. Let’s take a closer look at the details.
What is a Forward Delayed 1031 Exchange?
The Forward Delayed 1031 exchange is the most common type of exchange used by investors. It involves selling a relinquished property and later replacing it with a like-kind replacement property of equal or greater value.
While a property exchange could occur simultaneously, it is rare to be able to coordinate the timeline exactly, which is why most 1031 exchanges are delayed. A delayed 1031 exchange gives investors 45 days from the sale of the relinquished property to identify one or more replacement properties. Investors also have 180 days from the sale date of the relinquished property to close on at least one of the identified properties. Whether the property exchange is simultaneous or delayed, the key to a forward exchange is that the investor relinquishes the initial property prior to acquiring the replacement property.
What is a Reverse 1031 Exchange?
A reverse 1031 exchange occurs when the investor purchases the replacement property before selling the relinquished property. In its pure form, doing this would mean the investor would own both properties at the same time, which is prohibited by the IRS and would cause an exchange to fail. To stay in compliance with 1031 exchange rules, the transaction must involve an “accommodating party,” which is typically a 1031 exchange Qualified Intermediary (QI) who offers Reverse 1031 exchange services.
The accommodating party establishes a separate legal entity to acquire the replacement property and holds (or “parks”) the property for up to 180 days, which is known as an accommodation period. Generally, the investor must sell the relinquished property within this 180-day period. It’s important to note that to accomplish this transaction, the investor will need to provide sufficient funds to purchase the replacement property since the relinquished property has not yet been sold.
If the replacement property is the only property the investor plans to purchase, then the 1031 exchange can be completed upon the sale of the relinquished property. However, if the investor wants to purchase more than one replacement property, a combination forward-reverse 1031 exchange may be a viable solution.
Combining Forward and Reverse Exchanges
While there are some extra steps involved in a forward-reverse 1031 exchange, this process provides investors with a bit of extra flexibility. To clarify how this works, consider the following hypothetical example.
Imagine you have two investment properties, each worth $500,000, and you plan to sell them both. You’ve received an attractive offer to sell one property, but no offers on the other. You’ve also found the perfect replacement property, at a cost of $1 million.
Next, assume that the property you’ve received an offer on can close in 45 days and you can purchase your new property in 60 days. However, the fact that no acceptable offers have been received for your second property complicates matters. Using a combined forward and reverse exchange, you can have the proceeds from the sale of your first property sent directly to a qualified intermediary who can hold the funds on your behalf until you’re ready to purchase your new $1 million property.
After closing on the sale of the first property, you’ll identify a 50% interest in your planned replacement property. During this time, you’ll work with an accommodating party, also known as an Exchange Accommodation Titleholder (EAT), who takes title to the other 50% of your replacement property. Your accommodating party or EAT can do this by creating an LLC with the EAT as the sole member and lending the money needed to make the purchase to the LLC.
When you close on the replacement property, you will have 50% of the title in your personal name and 50% in the LLC, as tenants in common. Next, you can sell the second relinquished property and have the proceeds sent to your QI, who will use the funds to acquire the remaining 50% of the replacement property from the EAT, leaving you with 100% ownership of the replacement property and a successful 1031 exchange
An extended timeline is another benefit of a forward-reverse 1031 exchange. When you purchase a replacement property through an accommodating party agreement, you have 180 calendar days to sell the relinquished property. Once the relinquished property sells, you also have up to 180 calendar days to close on any additional replacement properties. This potentially extends the entire time to up to 360 days, giving you even more flexibility.
Some Final Thoughts
The process of combining forward and reverse 1031 exchanges can be a bit complex, so it’s important to work with a team of knowledgeable professionals. Tax and legal advisors can provide valuable advice, and an experienced qualified intermediary (QI) can guide you through the process, helping you avoid potential pitfalls. To learn more about 1031 exchanges, contact us to schedule a consultation with a member of our team.