Reverse 1031 Exchange

Requirements and Procedures

A reverse 1031 exchange occurs when the Replacement Property is acquired before the Exchangor sells the Relinquished Property, or in many circumstances before the Exchangor even locates a Buyer.

Requirements

For your property to qualify for a 1031 exchange, the following must be true:

Both the Relinquished Property and the Replacement Property must be held for either investment or productive use in a trade or business.

The property must be Like-Kind Property. Real property must be 1031 exchanged for real property.

There must be a reciprocal transfer of properties—a deed for a deed.

Two Methods to Accomplish a 1031 Reverse Exchange

You may use one of two methods to accomplish a reverse 1031 exchange. The first method is establishing a Special Purpose Entity designated by and affiliated with Downstream Exchange Company holding title to the Relinquished Property.

The second method is establishing a Special Purpose Entity designated by and affiliated with Downstream Exchange Company that purchases and holds title to the Replacement Property.

Method One

Holding Title to Relinquished Property

Procedures

Conveyance of Relinquished Property to Special Purpose Entity

Conveyance of Replacement Property to Exchangor

Sale of Relinquished Property by Special Purpose Entity

Conveyance of Relinquished Property to Special Purpose Entity

Exchangor provides Downstream with a copy of the deed or title report for the Relinquished Property.
Downstream has a deed prepared to transfer title from the Exchangor to the Special Purpose Entity designated by and affiliated with Downstream.
The Special Purpose Entity now holds title to the Relinquished Property.
When Downstream transfers the title of the Relinquished Property to the Special Purpose Entity, you will receive a letter from Downstream advising you of the date of the deed and a calculation of the 180th calendar day by which you must sell your Relinquished Property.

Conveyance of Replacement Property to Exchangor

The escrow company handling the escrow for the Replacement Property sends Downstream Exchange Company Escrow Instructions and the Preliminary Title Report.
Downstream prepares an Assignment Agreement, Exchange Agreement, Substitution Agreement, and Amendment to Escrow Instructions – Exchange of Replacement Property from that information. Downstream will send these documents to you for your signature as the Exchangor and to Escrow to obtain the Seller’s signature.
Since the Exchangor has not sold the Relinquished Property, the Exchangor has to lend the Special Purpose Entity sufficient funds to acquire the Replacement Property.
The Replacement Property you acquire must be a property you intend to hold for investment for at least one year. Since you have to keep the Replacement Property for investment, you cannot live in the Replacement Property.

Sale of Relinquished Property by Special Purpose Entity

The escrow company handling the escrow for the Relinquished Property sends Downstream Exchange Company Escrow Instructions and the Preliminary Title Report.
Downstream prepares a Substitution Agreement and an Amendment to Escrow Instructions – Exchange of Relinquished Property from that information. Downstream then sends these documents for your signature, as the Exchangor, the Special Purpose Entities, and to Escrow to obtain the Buyer’s signatures.
After the sale of the Relinquished Property has closed and the Escrow Company wires the proceeds to the Special Purpose Entity, the Special Purpose Entity repays the Exchangor the funds originally lent to the Special Purpose Entity to acquire the Replacement Property and, if applicable, pays down the loan obtained on the Replacement Property.

Method two

Holding Title to Relinquished Property

Procedures

Conveyance of Replacement Property to Special Purpose Entity

Conveyance of Relinquished Property From Exchangor to Buyer

Conveyance of Replacement Property by Special Purpose Entity to Exchangor

Practical Considerations

Important Issues to Take Into Consideration

Conveyance of Replacement Property to Special Purpose Entity

The escrow company handling the escrow for the Replacement Property sends Downstream Exchange Company Escrow Instructions and the Preliminary Title Report.
Downstream prepares an Assignment Agreement, Exchange Agreement, Substitution Agreement, and an Amendment to Escrow Instructions – Exchange of Replacement Property from that information. Downstream then sends these documents to you, the Exchangor, for your signature and to Escrow to obtain the Seller’s signature.
Since the Exchangor has not sold the Relinquished Property, the Exchangor has to lend the Special Purpose Entity sufficient funds to acquire the Replacement Property.
The escrow company deeds the Replacement Property to a Special Purpose Entity designated and affiliated with Downstream Exchange Company.
The Replacement Property you acquire must be a property you intend to hold for investment for at least one year. Since you have to keep the Replacement Property for investment, you cannot live in the Replacement Property.
When the escrow company deeds the Replacement Property to the Special Purpose Entity, you will receive a letter from Downstream advising you of the date of the deed and a calculation of the 180th calendar day by which you must sell your Relinquished Property.
The Special Purpose Entity will lease the Replacement Property to you, the Exchangor.

Conveyance of Relinquished Property From Exchangor to Buyer

The escrow company handling the escrow for the Relinquished Property sends Downstream Exchange Company Escrow Instructions and the Preliminary Title Report.
Downstream prepares a Substitution Agreement and an Amendment to Escrow Instructions – Exchange of Relinquished Property from that information. These documents are sent to you to obtain your signature as the Exchangor and to Escrow to obtain the Buyer’s signature.
The escrow company deeds the Relinquished Property to the Buyer.
Escrow on the Relinquished Property must close no later than 180 calendar days after the Special Purpose Entity receives the deed for the Replacement Property.
After the sale of the Relinquished Property has closed and the escrow company wires the proceeds to the Special Purpose Entity, the Special Purpose Entity repays the Exchangor the funds originally lent to the Special Purpose Entity to acquire the Replacement Property and, if applicable, pays down the loan obtained on the Replacement Property.

Conveyance of Replacement Property by Special Purpose Entity to Exchangor

According to the Exchange Agreement, the Replacement Property will be transferred to the Exchangor either by assigning 100 percent of the membership interest in the Special Purpose Entity to the Exchangor or by deed from the Special Purpose Entity to the Exchangor.

Practical Considerations

You need to have sufficient funds to acquire the Replacement Property.
You may incur additional state, county, or local transfer taxes when you deed the Replacement Property from the Seller to the Special Purpose Entity, from the Exchangor to the Special Purpose Entity or from the Special Purpose Entity to the Buyer.
You have only 180 calendar days from when the Relinquished Property or Replacement Property is deeded to the Special Purpose Entity to complete the exchange.
Some institutional lenders will not make loans to the Special Purpose Entity to acquire the Replacement Property even if the Exchangor guarantees the loan. If this is the case, the only method to accomplish the reverse exchange is Method One: Holding Title to Relinquished Property.

Important Issues to Take Into Consideration

Generally speaking, to completely defer all capital gain taxes:
- You must use all of the net proceeds from your Relinquished Property to purchase your Replacement Property.
- You must also obtain a mortgage on your Replacement Property equal to, or greater than, the mortgage on your Relinquished Property.
- You can offset the mortgage obtained on the Replacement Property by putting the equivalent additional cash into the exchange.
Certain losses may affect the amount necessary to invest in the Replacement Property. You should consult with your tax preparer regarding your potential Recognized Gain.
In a 1031 exchange, if the property exchanged is to or from a Related Parties, it must be held for two years. Please email, call, or fax us for a further explanation if you feel this may apply to you.
It is also essential that you do not have actual or “Constructive Receipt” of the funds during the exchange process. No funds from the transaction should be received by the taxpayer until all Replacement Property has been acquired
You cannot 1031 exchange stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidence of indebtedness, certificates of trust, or beneficial interest in a trust or partnership.
If you 1031 exchange California real property for out-of-state real property, California tax law provides for the nonrecognition of gain on the 1031 exchange. A 1031 exchange allows you to defer the gain and reduce the purchase price of the real property received; however, if you move out of California and then sell the replacement real property outside of California, the portion of the gain attributable to the increase in value of the California real property during the period you held it will be income from California sources. You must report income from California on California Form 540 NR.
California has enacted a new statute effective for real estate exchanged in an Internal Revenue Code Section 1031 tax-deferred exchange in tax years beginning on or after January 1, 2014. This new California statute requires that California taxpayers who sell and exchange California property for out-of-state property must file an information return (FTB 3840) with the Franchise Tax Board for the exchange year and every subsequent tax year. The purpose of this new statute is to allow the Franchise Tax Board to keep records of and then tax that taxpayer when they sell the out-of-state property.

The above information is provided for general information purposes only. You should discuss your actual individual property transaction with your current attorney, certified public accountant, or us.

We hope you find the above information helpful.

We know you will have questions about your transaction and encourage you to contact us. We will be pleased to assist you.

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