If you’re an investor considering a 1031 exchange, you know there are a few different types of exchanges to consider, including a reverse 1031 exchange. To answer the question, “Why do a reverse 1031 exchange?” we should first review the most common reasons why reverse 1031 exchanges take place. This will tell us a bit about the function and purpose of these exchanges and give us a sense of when they may be the best choice.
Two Variations of Reverse 1031 Exchanges
Before we cover the reasons behind reverse 1031 exchanges, let’s briefly go over the two variations of them.
When you decide to conduct a reverse 1031 exchange, you can execute either an “exchange-first” or “exchange-last” transaction. In an exchange-first transaction, you acquire the replacement property first and then subsequently convey the title to your relinquished property to the exchange accommodation titleholder (EAT). This is the least common of the two reverse exchange variations.
In an exchange-last transaction, the replacement property is initially acquired by the EAT and “parked” until you sell your relinquished property. Exchange-last transactions are the most common type of reverse 1031 exchange, and for a build-to-suit transaction, exchange-last is the only option.
Common Reasons to Do a Reverse 1031 Exchange
There are a few common reasons why a reverse 1031 exchange would make sense for you:
Capitalize on potential investment properties before selling property. If an investor has sufficient liquidity to purchase a replacement property or properties first, it may be advantageous to the investor to remove the risk of finding a replacement property within 45 days of sale closing assuming the likelihood of selling the current property is high.
Reduce potential tax liability. By purchasing the replacement property or properties first, an investor is able to remove some or all of the risk of triggering a tax liability from missing the requisite 1031 deadlines. In the event the property the investor intends to sell does not end up closing within the 180 days of closing on the replacement property, then no tax liability should be due. On the other hand, if the investor was to sell the current property and not be able to identify a property (up to three) within 45 days of the closing or close on an identified property or properties within 180 days of the sale closing, then a tax liability would be generated. The trade off is that the investor needs to have adequate liquidity in order to purchase the replacement property first and be willing to leave the cash in the new replacement property in the event the targeted exchange property does not sell.
You’re conducting a build-to-suit transaction. If you intend to conduct a build-to-suit 1031 exchange, then an exchange-last transaction is your only choice. A build-to-suit exchange involves the creation of a replacement property in the event that you cannot find an existing replacement property that suits your needs—or simply wish to develop your own.
In a build-to-suit exchange, the EAT will acquire and hold title to the developing replacement property and then convey title to you when the property is completed and you’ve disposed of your relinquished property.
These are just a few of many reasons to do a reverse 1031 exchange. Reverse exchanges offer you a variety of benefits over traditional exchanges. However, they also have more steps and require more time and effort in most cases.
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