The 1031 exchange and reverse 1031 exchange methods are some of the many ways through which investors can make extra profits while carrying out real estate transactions. However, these exchange methods are often mistaken to be the same. What is the difference between a 1031 exchange and a reverse 1031 exchange?
What Is the Difference Between a 1031 Exchange and a Reverse 1031 Exchange?
With a 1031 exchange, an investor sells a property and uses the proceeds to buy a new property, whereas, with a reverse 1031 exchange, the investor purchases the new property first and then sells the former property within a specified period of time. With a reverse exchange, investors can take the time to find just the right replacement property and actually close on it.
These methods of transaction obtain their name from Section 1031 of the U.S. Internal Revenue Code. One of their major advantages is that they allow investors to postpone payment of capital tax gains and other related federal tax liabilities on properties.
Rules for Carrying Out a 1031 and a Reverse 1031 Exchange
The internal Revenue Service Rules guiding the 1031 exchange and a reverse 1031 exchange include:
- You must exchange properties of the same kind.
- An investor can identify a maximum of three properties for replacement, provided they buy at least one of the properties.
- The new property must be of equal or greater value than the relinquished property.
- The qualified intermediary must be an independent entity without any form of relationship with either of the parties involved in the exchange for a period of at least two years prior to the exchange.
- The taxpayer can not receive the proceeds from the sale until the exchange process ends.
- All profits made during the exchange are taxable
- The taxpayer who swapped the relinquished property must be the same one who acquired the new property.
- The possessor must specify the replacement property for the asset exchanged to the intermediary 45 days after the sale.
- After the sale, the exchange process has to be completed within 180 days to qualify for tax deferment.
How Does a 1031 Exchange Work?
Although the 1031 exchange is fast becoming a popular way for investors to make a profit in real estate, it is not suitable for everyone. If you have assessed your options and decided on a 1031 exchange, it is important to understand the steps involved in carrying out a successful 1031 exchange in Northern Kentucky.
Enlist the Services of an Expert
While it is not compulsory for you to hire a real estate agency to guide you through a 1031 or reverse 1031 exchange process, it is quite the advisable thing to do. A qualified agency will assist you in compiling the necessary documents required during the process.
They also offer invaluable suggestions and strategies to help you maximize the benefits that come with a 1031 exchange as well as guide you in avoiding any hitches along the way.
Sole Ownership of Property
It is easier to carry out a 1031 exchange on a single-owner property than on a property owned by many individuals or on a property with a disputable title. This is because, in the former, no conflict of interest can arise between the owners to complicate or disrupt the exchange process.
Therefore, before deciding to begin a 1031 exchange, ensure that there are no disputes in the title and tax payments of the property that would be undergoing exchange. This helps you avoid any complications or possible disqualification of your property from the selection criteria.
Identifying the Property
A crucial step in exchanging properties is to know the type of properties that you can buy/sell and to ensure that they both meet the criteria for exchange. These properties have to be of a ‘like-kind’ or similar in characteristics.
The quality and grade of properties that would undergo trading are not necessarily taken into consideration. However, their site must be within the United States.
Selecting a Suitable Intermediary
An intermediary is an independent body, -whether an individual or a company- that can sign a written contract on behalf of the exchanger, agreeing to hold the proceeds from the exchange in an escrow account until the exchange process is done, after which the intermediary releases the funds to the owner of the replacement property.
Once the seller of the new property receives payment, the transaction is successful. However, remember that funding is a very sensitive matter when it comes to real estate, so it is critical to work with an approved and neutral intermediary who would safeguard your proceeds.
Selling the Relinquished Property
Following the selection of a qualified intermediary, the taxpayer looks for a suitable buyer for the property to be relinquished. Once the taxpayer identifies a buyer, both parties sign an agreement to close the sale of the property, and the funds would be sent to the intermediary.
Finalizing the Exchange
Once the taxpayer receives the profit, they can only use it to:
- Buy a replacement property of like-kind
- Pay closing costs or cover the mortgage or deed of trust on the relinquished property.
This entire process has to be completed within 180 days for it to count as a 1031 exchange and to qualify for tax deferment.
How Does a Reverse 1031 Exchange Work?
In a reverse 1031 exchange, an investor is allowed to acquire the replacement property even before they sell the relinquished property. Many investors are more inclined to this method of exchange as it allows them to take advantage of the market and sell their existing property at a possibly better offer.
The process of a reverse 1031 exchange differs slightly from that of a 1031 exchange. Here is what it entails:
Enlisting the Services of an Expert
The advantages of working with a professional real estate agency can not be overemphasized. A professional and experienced agency like Si Vales Valeo Real Estate will assist you in purchasing a replacement property and selling the relinquished property while making sufficient profit in the process.
Acquiring the Replacement Property
You should carry out a market survey within the United States for a replacement property that is like-kind to the one you are about to relinquish. After selecting your desired replacement property, you may pay for it using cash or through financing from a mortgage lender.
Choosing an Exchange Accommodator Titleholder
You should select a qualified exchange accommodator titleholder who accepts to hold the title of the property until the exchange process is completed. The exchange accommodator titleholder will typically sign a written agreement known as the Qualified Exchange Accommodation Agreement with the exchanger to confirm this decision.
Transferring the Property Title
After the agreement has been duly signed by both parties, the replacement property title is delivered to the exchange accommodator titleholder. This ensures that you are not in possession of the property until the process is completed. This process is termed Parking by the Internal Revenue Service.
Identifying the Property to Sell
Following the purchase of the replacement property, the taxpayer has a maximum of 45 days to select at most, three of their current investment properties for sale. The property(ies) chosen must be of equal or greater value to the property purchased.
Choosing a Qualified Intermediary
You would be required to select an independent body -an individual or a company- that will serve as a suitable intermediary during the exchange process. The qualified intermediary is responsible for transferring the property titles of both the replacement and the relinquished property to the parties involved in the exchange.
Finding a Buyer
Following the selection of a qualified intermediary, you can begin searching for a potential buyer for your relinquished property. Once a buyer for the relinquished property has been found, an agreement will be drawn and signed by both parties to confirm the sale of the property.
You must document that the exchange accommodator titleholder is the owner and seller of the property according to IRS rules. This is because the exchange accommodator titleholder is the current holder of the property.
Selling the Relinquished Property
The entire process of exchange, right from the purchase of the replacement property to the sale of the relinquished property must be completed within 180 days to qualify for tax deferment. Once the exchange is completed, the exchange accommodator titleholder receives the property title from the qualified intermediary.
If the replacement property is acquired through a mortgage, the qualified intermediary uses the proceeds from the relinquished property to cover the mortgage. Once the property title is duly cleared, the qualified intermediary legally transfers the ownership of the replacement property to the investor (you).
How Does a Property Qualify as Like-Kind in a 1031 Exchange?
Property can qualify as like-kind in 1031 exchange if it is identical in type to the property it is being exchanged with, regardless of its grade or quality. Both properties must also be held solely for business or investment purposes.
Note that primary residences, properties outside the United States, certificates of trust, bonds, stocks, partnership interests, and securities do not qualify as like-kind for a 1031 exchange.
The 1031 exchange and reverse 1031 exchange are both avenues that allow investors to upgrade and diversify their real estate investments and defer the payment of capital gains tax. With the information provided, you should understand the differences between both processes and apply the exchange that suits your current investment plan.