Capitalize on the Current Real Estate Market with a Reverse Exchange

With a typical 1031 exchange, you can sell your investment property without paying taxes when you purchase another investment property of equal or greater value. But, there's a hitch - you must sell your old property before you buy your new property within a strict 180-day time frame - in order to qualify for a 1031 exchange.

What happens if you need or want to purchase the new property before selling the old property? For example, you run into a delay on the sale of your old property or you want to take advantage of a down market to invest in foreclosed properties while you're waiting for the market to ramp back up - but you're not ready to sell your current property's? This is where the reverse 1031 exchange comes in.

...Sophisticated investors are using reverse exchanges to make purchases now, when the market is slow and prices are low...

The Reverse Exchange explained
Just as its name implies, a Reverse Exchange lets you to take advantage of the tax benefits of a 1031 exchange, but instead allows you to purchase your new property before you sell your old one.

In a reverse exchange, a Qualified Intermediary takes Title to the new property and holds it until you close on your old property. The Intermediary then transfers the new property to you to complete the exchange after you've closed on the sale of the old property.

The reverse exchange allows you to complete the transaction without taking Title to the new property and therefore being responsible for paying capital gains.

How the Reverse Exchange works 
One of the first things your Intermediary will do is to establish a separate entity or "company" to handle your reverse exchange in compliance with IRS procedures. This entity is called an "Exchange Accommodation Titleholder" (or EAT) by the IRS, and is usually structured as an LLC. The EAT will hold the Title of your new property until you've closed the sale of your old property.

You then obtain financing for the new property through the normal channels (traditional mortgage, etc.), and once you obtain financing, the lender will then send the monies to the closing or escrow company for the purchase of the property by the EAT.

Even though monies are loaned to the EAT, the loan is secured by your new property and guaranteed by you. In addition to a security interest in your new property, the lender will usually take a security interest in your old property in order to keep you committed to completing the exchange process. It usually benefits you, however, because the lender will take the equity and loan values of both properties into consideration when they analyze the loan. For this reason, investors often qualify for 100% financing for the purchase of the new property.

However if you do not qualify for 100% financing, the balance of the purchase price must come from you. This amount is also treated as a loan to the EAT. For example, if the new property costs $500,000, and the lender is willing to loan $400,000 for the purchase, this loan will be in the form of a first mortgage, or deed of trust, to the EAT. You will provide the $100,000 balance in the form of a second mortgage, or deed of trust, to the EAT.

When you close the sale of your old property, the proceeds from the sale will go to your Intermediary who will set up a closing to transfer, or "flip" the new property to you. The sale proceeds are then used to first pay back the equity that you put up. If there are funds remaining, they will typically go to pay down the bank loan, since any funds that go to you in excess of the money that you put in will be taxable. The bank loan will be transferred to you, the remaining balance will be re-amortized and the EAT will be dissolved.

Why today's market is perfect for Reverse Exchanges 
Reverse exchanges are the perfect "secret weapon" for the current real estate market as it appears close to bottoming out. Investors who sense that the market is preparing to turn want to take advantage of current market conditions to buy one - or maybe several - new properties at relatively low rates and then hold on to them for a year or so before selling them at a higher price.

Sophisticated investors are using reverse exchanges to make purchases now, when the market is slow and prices are low, and using reverse 1031 exchanges to maximize their profits. Once the market begins to pick up, the folks who were worried that any new real estate purchases would continue decline in value will come out to shop for properties.

Finding a Qualified Intermediary 
Finding a knowledgeable and reliable Qualified Intermediary who specializes in reverse exchanges is the single most important key to a successful reverse exchange. Here's what to look for:

In a 1031 exchange, the seller can't touch the money, so the Intermediary holds it for him or her. Avoid intermediaries who co-mingle or "pool" your money with other investors' funds and instead look for one who uses segregated accounts at a federally insured bank - and who will provide you with the interest on your funds.
Insist on "transparency." Although you cannot touch any funds - otherwise you'll taint your exchange - you should be able to see your money. Don't rely on paper bank statements, which can be easily forged. Ask for bank names, account numbers, and passwords.
Look for an Intermediary who is nothing but a 1031 intermediary. Go to someone whose life is on the line for your exchange. Ideally, they'll be willing to represent you for free if you're audited.
Reverse exchanges are a great way to invest in lower priced properties now - without having to take Title to them until you sell properties you're currently holding. Look for a Qualified Intermediary who specializes in 1031 and reverse exchanges, make sure you have complete transparency with regard to your funds, and find an Intermediary who will represent you should you get audited. Following these tips will ensure your exchanges are glitch- and tax-free!