Standard 1031 exchanges offer the benefit of being able to defer capital gains taxes and depreciation. In fact, this can be done almost indefinitely, as long as the proceeds of the sale aren’t touched by the investor and the other conditions are met.
But what should an investor do if a deal falls through right after they find the perfect replacement property? And is there a way to use an exchange when construction needs to take place on raw land?
An exchange can also be carried out in these instances as well, with some specific caveats.
Reverse 1031 Exchanges
Normally an exchange is executed before a replacement property is found. Often the owner prepares to sell an income property, begins the 1031 exchange, and then searches for a replacement property.
Occasionally, however, a seller might find a replacement property before they sell the relinquished property, or perhaps a deal has fallen through. In this case, an exchange can still be done: it’s called a reverse 1031 exchange. It works by having the company doing the exchange take title of one of the properties, either the replacement property or the relinquished property.
Since time is critical in reverse 1031 exchanges, investors need to make sure they get any necessary documents in as quickly as possible. Some of these documents might include:
- a copy of the purchase contract
- a copy of the title report
- Phase 1 environmental report
- property insurance needs to show that exchange company owns the property
- proof of liability coverage for the property
Another important factor is whether the lender is willing to participate in the 1031 exchange as an overseer.
This is necessary because most loans are recourse loans, preventing the owner from transferring title to anyone other than the owner unless a sale is taking place. Since the exchange company will legally hold the title, your lender needs to approve adding non-recourse language to the loan documents and allow the property to be transferred to you when the exchange is completed. Regardless, investors should make sure to discuss the possibility of executing a reverse exchange with a lawyer beforehand.
Construction 1031 Exchanges
Construction 1031 exchanges are useful when an investor would like to use the money from the property being sold to make improvements on the replacement property. The value of the property and the cost of the improvements must be the same as or greater than the value of the old property in order to qualify.
In addition, all improvements must be made and the title conveyed by the 180th day, which could be tricky in a construction exchange. This might necessitate favoring speed over cost reduction, in order to ensure you are able to benefit from capital gains tax deferral and recaptured depreciation.
Safe Harbor Reverse Construction 1031 Exchange
A construction 1031 exchange can also be paired with a reverse exchange, allowing you to purchase a replacement property and make improvements on it before you sell the relinquished property. You can also purchase raw land and build to order.
The same deadlines still apply: no more than 180 days may pass in order to defer capital gains taxes and appreciation, plus, the cost of building on the land or constructing the property plus the value of the property itself must be greater than the value of the relinquished property.
Non-Safe Harbor Reverse Construction 1031 Exchange
Since getting all the necessary permits and completing construction on a new property often takes more time than the allotted 180 days, many investors choose to use what is termed a non-safe harbor reverse loan. In this type of exchange, there is no limit where the exchange must be completed.
In this type of exchange, an exchange company forms an LLC and acquires the property, completing all the necessary improvements. Once construction is completed, the LLC sells the property at a cost to the investor as their replacement property. The investor has up to six months from the sale of his relinquished property to buy the replacement property, so timing is crucial in this type of exchange.
Two important facts to keep in mind: The exchange company may not the taxpayer’s agent in a non-safe harbor exchange, and a traditional mortgage lender cannot be used, which means a commercial lending bank or private lender must be used. Sometimes the exchange company provides a loan to the LLC, or both the exchanger and the LLC can find another source which will fund the property purchase along with the construction.
Leasehold Improvement Exchange
With this type of exchange the investor purchases the property – usually land – before any construction takes place, or in some cases, they may already own the land.
The exchange company forms an LLC and then leases the land from the investor for a 30-year lease, completing the improvements on the land. Once construction is completed, the investor buys back the exchange companies remaining interested in the 30-year land lease and uses this improved property as a replacement property.
1031 exchanges can offer numerous benefits to investors – if you know how to avoid the pitfalls that may invalidate your exchange. For example, what should you do if more than one person owns the relinquished property? And what do you do if a group of people owns the relinquished property, have agreed to sell it, but not all of them agree to buy a replacement property? These are complicated questions, and a wrong answer could cost you hundreds of thousands of dollars.