Basic 1031 Exchange (also known as a straight or forward exchange)
Fred owns a condo in Sarasota that he purchased in 2010 for $200,000. Over the years he has rented out his property to various tenants, and occasionally used it himself for him and his family to enjoy a nice vacation in Florida.
Fred has decided it's time for him to sell his property and reinvest in another property that's slightly larger. His intentions stay the same - he plans to rent out this new property to tenants while occasionally using it for family vacations. Luckily for Fred, home values have gone up and he can now sell his condo for $360,000. As Fred is getting ready to sell, he realizes that he has a large gain that be will taxed by the government as capital gains tax. He could potentially be looking at having to send a $32,000 check over to Uncle Sam for capital gains tax - this was not part of his plan! Luckily, Fred's CPA tells him about 1031 exchanges and how this would allow him to defer his capital gains tax and use it towards the purchase of his new property instead.
After talking to his CPA, Fred gives 1031 Exchange Connection a call to learn about 1031 exchanges. After we explain to him the 6 rules and the 1031 exchange process, Fred is ecstatic and is on board to do an exchange. Once he enters into a contract, he sends us all needed information, an agreement is written, and instructions are delivered to the closing agents.
On the day of closing, proceeds from the sale of the relinquished property are wired to 1031 Exchange Connection to hold as his Qualified Intermediary. On this day, the 45-day identification process begins, and Fred starts searching for up to 3 replacement properties he is interested in purchasing. Because Fred wants to defer all of his capital gains tax, he is going to make sure that all of the properties listed are equal or greater in value to the sale of his relinquished property. Concurrently, this is also day 1 of the 180-day closing period of the replacement property.
On day 45, Fred submits his final 45-day identification form. He now has 135 days left of the 180-day closing period to close on one of the replacement properties he has identified. He decides to purchase a property from his list for $500,000. Fred then enters into contract on one of those properties identified on his form. He submits all needed information to us, and once again we prepare all necessary legal documents and instructions. Fred schedules the closing before the end of the 180-day period, and 1031 Exchange Connection wires the funds from his relinquished property over to the closing agent handling escrow on the buy side on the day of closing to use towards the purchase of the replacement property.
Reverse 1031 Exchange
Let's take Fred's situation from above; he has a condo that he purchased for $200,000 which he has rented out to tenants and occasionally used for personal enjoyment over the past 3 years. He is looking to sell and reinvest, but this time he has already found the perfect property.
He wants to purchase this property before someone else does, but he hasn't yet sold his old property. This property is selling for $360,000. Fred knows if he does a 1031 exchange he'd be able to defer all of the capital gains tax by reinvesting all of his cash from the sale of the old property, and he doesn't want to miss out on that.
This is the perfect opportunity for Fred to do the reverse exchange. Because Fred has held this property as an investment, this qualifies him to do a Safe Harbor Reverse Exchange as long as he intends on also holding the replacement property for at least two years, renting it out at a minimum of 14 days each year.
In this case, Fred is going is to use 1031 Exchange Connection as his qualified intermediary to purchase the replacement property for him. This is to avoid holding title to both properties at once, which would void the exchange. How is Fred able to do this when he doesn't have the funds from the relinquished property yet? While this might seem like a financial obstacle, he has a few options: purchase the replacement property in all cash, receive financing from his bank or lender, or a combination of both.
Let's just say in this example that Fred has the cash needed to purchase the replacement property. He will go ahead and supply, or lend, us the funds, and we as his qualified intermediary will purchase the replacement property for him in an Equity Accommodation Titleholder (EAT) until the old property sells. This is done so Fred does not hold title to both properties at once, which would toast his exchange.
Prior to closing on the new property, all documents and instructions are given to prepare for the exchange. Starting on the day of closing on new property, Fred has 45-days to properly identify with us the property that he is selling (this would be his old property). According to the IRS in rev. proc. 2000-37, or the Safe Harbor Reverse, Fred will have 180 days starting from the day of closing on the new property to sell his old one.
One of the greatest things about a Reverse 1031 Exchange is should it take longer than 180 days for Fred to sell his old property, the 180 days is "soft", meaning we can go past them if needed. The reverse exchange stays intact, however it will just no longer be under the guidelines of the Safe Harbor. 1031 Exchange Connection and Fred just need to revise the exchange documents to allow the EAT to continue holding onto the new property and give him more time needed to sell his old property.
Once Fred closes on his old property, title on the new property can now be arranged to be transferred over to him. Remember, in the eyes of the IRS, Fred did not hold title to both properties at the same time during the entire reverse exchange, because the new property was being held with us as the QI until the sale of the old. Keeping with Rule 5 of a 1031 exchange, Fred will also take title to his new property in the same manner he held title to the old property. This is to fulfill the same taxpayer requirement as mandated by the IRS.
The Common Theme?
Whether it was the forward or reverse exchange, in each situation Fred was able to defer thousands of dollars in capital gains tax by rolling his gain over into his new property. When the deal was done, Fred was left with a great new investment property without the hefty tax bill!