Reverse Exchange Activity Has Increased

What Is A Reverse 1031 Exchange?

Most real property investors are familiar with a regular Forward 1031 Exchange whereby an investor sells his or her current rental or investment property and then exchanges into another property in order to defer the payment of their taxable gains.  The sale of the relinquished property occurs first and the subsequent purchase of their replacement property must occur within 180 calendar days from the date of the sale.  The Reverse 1031 Exchange is the opposite whereby the real estate investor can buy their replacement property first and then sell their relinquished property later.  Reverse Exchanges can give an investor a leg-up in high velocity real estate markets like today.

1031 Exchange Activity Up Substantially

You have no doubt read numerous articles recently that have been discussing news that 1031 Exchange transaction activity is way up.  We have not only heard but have experienced the same thing.  1031 Exchange volume has in fact exploded over the last 12 months or so, and the exchange activity trend continues to look very good indeed.

Reverse Exchanges Increase More Than Regular Exchanges

As we analyzed our 1031 Exchange transaction detail, we noticed an underlying trend - Reverse 1031 Exchange activity had not only jumped as well, but had jumped significantly more than Forward 1031 Exchanges on a percentage comparison basis.  It's certainly not surprising when one looks at the underlying real estate market velocity - its been a crazy real estate market.  Investors are competing with multiple offers and bidding wars in many real estate markets.  This can make a Forward 1031 Exchange stressful for the less sophisticated investor due to the strenuous 1031 Exchange deadlines involved. 

Market Risks Complicate Forward 1031 Exchanges

Regular or Forward 1031 Exchanges mean that investors sell his or her relinquished property first and then they have 45 calendar days to identify their replacement property and an additional 135 calendar days to acquire and close on the replacement property for a total of 180 calendar days for the entire 1031 Exchange.  The problem is that when a sale of relinquished property closes the depreciation recapture and capital gain tax liabilities are recognized.  Investors must identify and subsequently acquire and close on their identified replacement property acquisitions in order to defer the payment of these taxable gains.  If they can't then their 1031 Exchange fails and they must realize their depreciation recapture and capital gain taxes.

Reverse Exchange Helps Minimize Market Risks

This market risk exposes investor to potentially failed 1031 Exchanges, and explains why Reverse 1031 Exchanges have become so popular over the past 12 months or so.  The Reverse Exchange gives an investor the ability to take all the time they want to locate and acquire suitable replacement property, including doing their due diligence, before they sell their relinquished property.  The market risks involved in a Forward 1031 Exchange (i.e. identifying property within 45 days and completing the exchange within 180 days) because they actually acquire and close on their replacement property first so there is no risk that they will not be able to located, identify and acquire the replacement proeprty within the deadlines.

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California Puts Claw in Claw Back Law

Sale of Real Estate Triggers Tax

When a taxpayer and/or investor sells real property the sale generally triggers a capital gain tax (or loss), and if it is rental, investment or business use real estate, it may also trigger depreciation recapture tax.  These taxes are due in the year in which you sell or dispose of the real estate.  However, there are methods for deferring the payment of these taxes, including a tax-deferred exchange transaction for investment real estate pursuant to Section 1031 of the Internal Revenue Code ("1031 Exchange"). 

Defer Tax With A 1031 Exchange

Real estate investors normally do not realize and pay these capital gain and depreciation recapture taxes because they structure their sale of the real estate through a 1031 Exchange.  In fact, most investors rarely pay these taxes because they will continue to 1031 Exchange throughout their lifetime and their heirs will receive a step-up in cost basis (i.e. the capital gain and depreciation recapture taxes completely go away) at the investor's death.   

Selling Property In One State; Buying In Another

However, what happens when the investor sells their relinquished property in one state - say the State of California - and then reinvests through a 1031 Exchange in replacement property located in a different state?  The majority of states just look the other way, and those that have tried to address it via legislative action do not really enforce it.  The State of California is a different matter and investors need to be aware of recent changes to California tax law. 

California Claw Back Requirement

California has always taken the position if you sell rental, investment or business use real estate in California and defer the payment of your capital gain tax and depreciation recapture tax through a 1031 Exchange by acquiring replacement property in another state other than California that they want their fair share of the capital gain and depreciation recapture taxes if and when the investor ultimately sells the real estate, "cashes out" and pays their tax in the future.  This tax policy is often referred to as the California Claw Back because the State of California insists on "clawing the tax revenue back" from the other state when the investor ultimately sells and incurs the tax liability.  However, the State of California had no effective way to track, monitor or police taxpayers when they 1031 Exchange out of California investment property and into real estate located in another state, until now. 

California Puts The Claw In The Claw Back Law

The State of California passed new legislation in 2013 that effectively puts the "claw" into the California Claw Back.  The new law is effective for any sale of rental, investment or business use property that closes on or after January 1, 2014.  It requires that the investor file an information return with the State of California.  The information return must also be filed each year thereafter keeping California in the loop so that they know if and when the investor ultimately sells and cashes out and therefore owes California their share of the taxes. 

Gift Limit Increased by IRS for 2013

Taxpayers are allowed to "gift" real estate, personal property and/or money to other individuals without having to pay any kind of corresponding taxes because of the gift provided the taxpayer follows certain gift limitations set forth by the Internal Revenue Service. 

Annual and Lifetime Gift Limits

The are two (2) different types of gift limitations.  There is the annual gift limitation and there is the lifetime gift limitation.  These limits are established by Congress and administered by the Internal Revenue Service. 

Annual Gift Limit Increased for 2013

The annual gift limit is set annually by the Internal Revenue Service pursuant to a formula pre-established by Congress.  The Internal Revenue Service just announced that the Annual Gift Limit for 2013 has been increased to $14,000.00 (it was $13,000.00 for 2012).

Tax Benefits of a 1031 Exchange Should Not Overshadow Financial Benefits

Real estate investors frequently jump into acquisitions of replacement real property as part of their 1031 Exchange transaction, and that may not be well suited for their investment goals and objectives.  The rush into these investments is certainly understandable due to the stress placed on the investor due to the 1031 Exchange deadlines involved.

Tax Benefits Should Not Guide Investment Decision

However, while the tax benefits related to structuring the 1031 Exchange are certainly important, the financial and economic elements of a replacement real property should not be ignored simply because of the 1031 Exchange identification and completion deadlines. 

Real estate investors should let the economics of the replacement real property guide their final investment decision instead of making their decision based solely on the income tax benefits involved by 1031 Exchanging into another replacement property.

Delaware Statutory Trusts

Delaware Statutory Trusts, also referred to as DSTs, can also provide another investment vehicle for real estate investors to consider.  The more options the real estate investor has at their disposal the more likely he or she will find the most suitable investment for their 1031 Exchange and not be forced into "jumping" into the wrong investment. 

Real Estate Economic & Demographic Trends, Analysis and Forecasts

The World and the West

The "Great Recession" has left many of us scratching our heads and wondering what's next?  Where do we go from here?  How should we re-position our real estate portfolio going forward now that we are emerging from the recession?  Should I hang tight, or make an investment move now?

Make Better Informed Investment Decisions

We realize these are confusing times, which is why Exeter 1031 Exchange Services, LLC is hosting this webinar for you.  Our goal is to provide you with up-to-date real estate market data and information so that you can make better informed investment decisions.

This exciting webinar will provide an update on the real estate market on a local, state, national and global point of view as well as an overview of certain demographic trends that will affect investment real estate.  It will help you answer the above questions, and help you decide how to position your own investment portfolio as we move forward beyond the recession. 

Advanced Registration Is Required 

Click here to register for this webinar on economic and demographic trends.