Everything You Need To Know About The 'Reverse 1031' Tax Workaround

Real estate investors have been using conventional 1031 Exchanges to swap buildings and hurdle big chunks of capital gains taxes. But 1031 Exchanges come with a tight timeline that's hard to abide by in these market conditions. So here's Bisnow's breakdown of a spin on the 1031 that lets buyers duck its normal deadline.

Fast Facts:

• 1031 exchanges let investors save up to 30% in capital gains tax on a sale by deferring the tax bill tax free onto another property within a six-month deadline.
  
  
• In a seller's market, finding a buyer is pretty straightforward. It's finding a good deal for your 1031 credit that becomes tricky—especially within the tight deadline.
• To get around that, so-called "reverse 1031" exchanges let buyers snag their replacement property before selling the old asset.
  
  
• In a reverse 1031, seller puts the funds from their sale directly into another building, rather than taking it in as income.
  
• Still under the radar for most investors, the reverse 1031 helps in a seller's market, where high prices, tight lending guidelines and compressed cap rates make it tough to find a replacement.
  
  
• Reverses aren’t for everyone—they work best in the high-end market with big-name clients.

The Reverse Process

In a seller's market, finding good deals can be a challenge, especially when competing with foreign investors utterly unconcerned about short-term yield. Instead, investors have been taking advantage of a little-known spinoff called the "reverse 1031."

According to Michael S. Brady, lawyer and VP of New York title company Riverside Abstract and sister company Riverside 1031, the reverse 1031 allows real estate investors to create a third-party “Exchange Accommodation Titleholder” (EAT) to secure a new property before they sell their old one.

This, in turn, lets the investor transfer earning—untaxed—directly into the new digs. The investor can’t own both properties at the same time, so they have to park the title of one with the EAT, Michael tells us. “In lieu of the taxpayer taking title to the relinquished property, the EAT will buy it and hold it until the taxpayer is ready to sell their property.”

Apparently, Things Are Quicker In Reverse

All 1031s let real estate investors get around up to 30% in capital gains taxes, but Michael tells us that the forward variety's short timeline can be tricky. “You don’t want to get caught without a replacement property after you’ve sold your original property,” Michael says. 

Reverse 1031 investors decide they want to pick out the replacement property first, before they find a buyer for the original property, which tends to be the easier side of the deal. 

When investors do line up an ideal property they’ll want to snag it ASAP, before getting undercut by another customer—the reverse 1031 lets them speed up the process.

The Catch: High-Rollers Only

The lenders have to cooperate for a reverse exchange, which may be a problem. Banks are skeptical about lending to the third-party EAT where they have no recourse in case of a default.

Michael says lenders are more comfortable with multimillion-dollar transactions, rather than ones under $1M, where there just isn't much incentive to pique a lender's interest. “The sweet spot is about $5M to $10M,” he tells us.

He adds that often people with more expensive properties will already have a solid relationship with the lender, making it easier to get financing. A second caveat: if for some reason you can’t sell your property within the 180-day max period then you can get stuck holding both properties.