Why 1031 Exchange?
We all know about the power of compounding. By deferring capital gains taxes from our investment property sale, we’d have a bigger investment base to continue to compound.
A 1031 exchange is a powerful tool for real estate investors to defer capital gains taxes. Some seasoned investors practice “swap until you drop” so they can continue to defer taxes through multiple exchanges and their heirs can receive the properties tax free when the parents pass. The estate tax exemption limit is $13.61MM per individual as of 1/1/2024. That’s a lot of taxes to be deferred and exempted.
This article is intended for real estate investors wanting to upgrade their portfolio while deferring capital gains taxes. We Abundance offers a financing solution making Reverse 1031 Exchange easy and compelling for these investors.
Keep in mind – Consult with your own tax advisors and 1031 Exchange qualified intermediary re: the rules and regulations of 1031 Exchange. We Abundance are by no means qualified to give any tax advice.
Differences between a Traditional 1031 Exchange and a Reverse 1031 Exchange?
The primary difference between a reverse and a traditional 1031 exchange lies in the sequence of the buy and sell transactions.
With a traditional 1031 Exchange, an investor would sell first, then buy. Once an investor has sold the existing property (“relinquished property”), he/she has a mere 45 days to identify the new property (“replacement property”) and 180 days to close escrow on the purchase using the sales proceeds from the relinquished property. The qualified intermediary (“QI,” also known as an exchange facilitator) holds your sales proceeds until you complete your purchase.
As you can imagine, 45 days to find a replacement property can be challenging, especially when there is limited supply. Many investors delay their exchanges in fear of not finding something suitable within the 45 days, and as a result having to pay capital gains taxes or suffer with an inferior replacement property.
With a Reverse 1031 Exchange, an investor would buy first, then sell. An investor has 45 days from when they close escrow on the purchase of the replacement property to identify the property they want to sell, and a total of 180 days to close escrow on the sale. This is a much more relaxed timeline. The QI holds your replacement property until you complete your sale.
Why use a Reverse 1031 Exchange?
In a nutshell, Reverse 1031 Exchange allows investors to capitalize on a great investment opportunity immediately without having to wait to sell their current property. As most investors already know which property or properties they want to sell, the 45-day identification deadline is easy. Selling a well-priced property within 180 days is generally not a challenge either. The dreaded timeline pressure from a traditional 1031 Exchange is much reduced in a Reverse 1031 Exchange.
Hence, Reverse 1031 Exchanges are preferred by the more sophisticated, more strategic investors.
Where is the money?
But how do you buy something without the sales proceeds from the existing property? Below are the most common options:
1. Use your cash on hand;
2. Use you line of credit secured by other assets (e.g., your stock portfolio, or other rental property);
3. Use a hard money loan for 100% of the purchase; or
4. A combination of the above – e.g., cash on hand for the down payment, and hard money loan for the balance.
For most real estate investors who are dirt rich, cash poor, that 3rd and 4th option opens doors. That’s Reverse 1031 Exchange financing.
How does Reverse 1031 Exchange financing work?
On a reverse 1031 exchange, an investor would buy the new property through a qualified intermediary (QI, also known as an exchange facilitator); and title to the new property would be held in the name of a newly formed, single purpose LLC, managed by the QI.
As a private lender, Abundance would secure its bridge loan as a 1st mortgage on the new property, and possibly also as a 1st or a 2nd mortgage on the existing property or another property not involved in the exchange. By cross collateralizing the loan with multiple real properties, Abundance can potentially offer a higher loan amount while still maintaining a conservative loan-to-value (LTV).
In either case, Abundance would fund borrower’s purchase through escrow, with the newly formed LLC as the borrower, and the principal beneficiary of the exchange as the personal guarantor for the loan.
When the existing, relinquished property is sold, the sales proceeds would be used to pay down or pay off the hard money loan. Ownership on the new property would be transferred from the newly formed, single purpose LLC, to the original ownership entity, who also assumes the balance of the loan. Then the borrower can re-finance the remaining balance, if any, into a conventional loan.
How much can I borrow from Abundance?
For residential properties in California, we Abundance can lend up to 75% combined loan-to-value (CLTV) using both the new property and the existing property as collaterals. See diagram below for an example CLTV calculation.
What are the steps to a Reverse 1031 Exchange financing?
Assuming a very simple 1:1 exchange, here are the basic steps:
Make offers for New Property as “<Your Name> and/or Assigns”
With your Qualified Intermediary (QI), form a new, single purpose LLC as Exchange Accommodation Titleholder (EAT)
Calculate your desired short term loan amount to complete the purchase
Fund and close escrow on the purchase, with EAT as owner:
Abundance as 1st deed lender to EAT on New Property and as 2nd deed lender on Existing Property
Your own funds (down payment, if any) as 2nd deed lender to EAT
You close escrow on the sale of your Existing Property:
Sales proceeds fund EAT to pay down/off your Abundance loan;
Take title and assume Abundance loan on New Property.
We Abundance (or another lender or mortgage broker of your choice) help you re-finance to a lower rate, permanent financing
Disclaimer – Make sure you talk to your qualified intermediary and your tax advisor to confirm the details of the IRS regulations on 1031 Exchange.
What are the typical cost of a Reverse 1031 Exchange loan?
The typical cost of a reverse 1031 exchange loan is similar to other hard money loans. It depends on loan-to-value (LTV), the principals’ credit worthiness, and the supply & demand of funds. Usually the interest rate is slightly higher than prime, and the loan origination fee is 1.5% to 3% of the loan amount.
The faster the existing property is sold, the less interest the exchanger needs to pay. In our experience, reverse 1031 exchange usually only last 2 to 3 months.
The cost of a reverse 1031 exchange loan is minuscule compared to the 35%+ capital gains taxes one would need to pay, plus the ordinary income tax on the depreciation recapture.
What are the risks of a Reverse 1031 Exchange loan?
The primary risk of a reverse 1031 exchange loan, to the borrowers, is the IRS timeline of 180 days. If the existing property doesn’t sell within 180 days, you may own both properties and having to service the hard money loan on the new property without the tax deferred sales proceeds. So, make sure you are ready to complete the exchange within 180 days.
Second, you should make sure you can comfortably get permanent financing for the remaining loan balance on the replacement property once you’ve completed your reverse 1031 exchange. For example, if you’re buying a commercial property or a mixed use, where a traditional lender will want debt service coverage ratio (DSRC) exceeding 1.2 or 1.35, you should get that all nailed down before you pull the trigger on the purchase. You don’t want to be stuck with a short-term hard money loan for too long.
Why don’t conventional lenders work with Reverse 1031 Exchange?
Reverse 1031 Exchanges generally last no more than 180 days, as required by the IRS. Most traditional lenders want long-term residual income from the interest, not short-term loans.
In addition, Reverse 1031 Exchange loans are made to a newly formed, single purpose LLC managed by the QI or exchange facilitator. Most residential lenders don’t work with LLCs.
Hence, hard money lenders are the primary resource of Reverse 1031 Exchange financing. Few hard money lenders offer it because they are not real estate investors and have no experience navigating through a reverse 1031 exchange.
Three real world examples
The diagram above shows a simple 1:1 reverse exchange.
You can combine forward and reverse exchanges as well. A couple of years ago, we sold our Albuquerque apartment complex and exchanged into two single family homes (SFHs) in the San Francisco Bay Area. We decided to do a reverse 1031 exchange to buy SFH #1 first before the Albuquerque apartment complex closed escrow; and then a traditional forward 1031 exchange to buy the SFH #2 afterwards. Doing so, we had more time to find the right properties. On SFH #1, we did a reverse exchange. When the apartment complex closed escrow, we completed the reverse exchange and re-financed to a conventional loan. And then we got a conventional loan to purchase SFH #2. Looking back, we got a good deal on SFH #1 and probably over-paid a bit on SFH #2, because of the 45-day identification deadline. Still, we are very glad we upgraded our portfolio and deferred substantial capital gains taxes.
Another client decided to sell 4 properties in Ohio to buy 1 in SF Bay Area. He sold 2 properties first, and applied the sales proceeds as down payment towards the SF Bay Area replacement property purchase. The balance of the purchase price was a reverse 1031 Exchange loan from Abundance. When he closes escrow on the sale of the remaining two properties (within 180 days), he will use the sales proceeds to pay down the Abundance loan and complete the reverse 1031 exchange. We will then help him re-finance the balance to a conventional loan once the property ownership has been transferred back to his original ownership entity.
Consult your tax professionals and qualified intermediaries
Yes, reverse 1031 exchange can be complex, but it can also be very rewarding. We are happy to brainstorm with you and introduce you to the trusted advisors we’ve used – tax attorneys and qualified intermediaries. Call Elsie at 510-468-4508, or Eric at 408-910-6168.
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