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May 23, 2024 | read

100. How Reverse and Improvement 1031 Exchanges Can Offer Flexibility

Ben Isley

In this episode, we’re joined by Tom and Andrew Gustafson of Atlas 1031 Exchange. Atlas 1031 provides qualified intermediary services to accommodate and facilitate simple and complex 1031 exchanges. Today we discuss the aspects of reverse 1031 exchanges, a strategy that allows you to acquire a replacement property prior to selling the property you wish to exchange, improvement exchanges, and the impact the Coronavirus crisis has had on 1031 exchange timelines.

1031 Exchange

We have covered the fundamentals of 1031 exchanges and forward 1031 exchanges with Bill Exeter. If you’re unfamiliar with this topic, consider checking out our podcast Episode 22 with Bill Exeter.

Section 1031 is an Internal Revenue Code section that allows for the deferral of capital gains for both state and federal as well as depreciation recapture for the sale of properties that are held for trade, business, or investment purposes. In a forward exchange, the taxpayer may sell the property and reinvest those proceeds and debt into a replacement property, therefore deferring their tax obligation if done correctly and fully.

Reverse Exchange

This is a different tool than a traditional forward 1031 exchange. Essentially, a reverse exchange allows you to acquire the replacement property before the sale of the original property. In forward exchange, the relinquished property is sold first, and a replacement property must be acquired within 180 calendar days. There are many similarities with the reverse exchange, but also some key differences.

This information comes from Revenue Procedure 2000-37 and was further modified in Rev. Proc. 2004-31.

The reverse exchange allows the exchanger to take their time to acquire the replacement property first. This type of tool allows you to be much more focused on the replacement property first. In a reverse exchange, the property to be sold must be sold within 180 calendar days following the acquisition of the replacement property. The replacement property must still be of equal or greater value, you must reinvest the entire net sales price into the replacement property. This property can’t also be your primary residence or a vacation property. All of these points also apply to forward 1031 exchanges, so where do they differ?

The exchanger may not simultaneously hold both properties. One property must be “parked” with an Exchange Accommodation Titleholder (EAT). This is one of the first considerations. In a reverse exchange, you still need to indicate ahead of time, as part of the contract, that you will be performing a reverse 1031 exchange.

When to Involve Atlas 1031/ A Qualified Intermediary

As early as possible. As soon as you determine you want to move forward, you should contact a Qualified Intermediary to review the details and ensure you meet IRS criteria. Call number 2 is to your CPA or Tax Adviser to ensure this is in your best interest.

Downsides of Reverse 1031 Exchanges?

Reverse 1031 exchanges are much more expensive than forward exchanges. They are much more complex and have more moving parts. Cost is likely the biggest downside. Another downside is the involvement of other outside services. The insurance underwriter and lender are typically much more heavily involved. One risk is that you may still own two properties at the end of the cycle if your relinquished property doesn’t sell within the 180 calendar day window. Local tax authorities also handle these title changes differently, some areas may be more expensive.

Improvement Exchanges

Improvement exchanges the investor/taxpayer to make improvement to the acquired property using exchange funds. Improvement exchanges are made up of two things: 1) The real property that’s being acquired and 2) Improvements (materials and labor). The materials and labor doesn’t become real property until it’s affixed to the real property. The EAT must take title to the real property. A common pitfall in the improvement exchange is the failure to properly estimate the time required for the soft costs, such as architectural fees, permits, surveys, etc.

TCJA 2017 Rule Changes

Personal property was removed from the code, only real property was preserved. Prior to the TCJA, items such as cars, aircraft, heavy machinery, collectibles, antiques, appliances could be exchanged. Now, purely real property can be involved in these exchanges unless the personal property is incidental (less than 15% of the total cost). Personal property can be bundled if it’s incidental.

Coronavirus Timeframe Changes

On April 9th, an IRS notice was released to state that the windows of time that come to close between April 9th and July 14th get extended to July 15th. Practically, this means that properties falling in this window will have their end date changed to July 15th. This extra time can be very valuable to identify the property.

Learn more about Atlas 1031: https://atlas1031.com/