Once in a while, it’s fun to discuss a topic that’s a little esoteric. While 90 percent of real estate investors will probably never have reason to be involved in a reverse deferred exchange, for those who do, here’s a little introduction. Before I continue, I must give my regular disclaimer. As I’ve said many times, I’m not an accountant, so before you decide to leap into any complicated financial decisions, please be sure to discuss them with people trained to provide expert accounting advice.
Here we go. When you buy an investment property, your tax basis is established based on the acquisition cost, and this will impact the taxes you pay when you eventually sell the property. The tax basis is loosely defined as the acquisition price plus the acquisition costs plus improvements during the time you own the property minus depreciation.
Let’s imagine you purchased a residential property 23 years ago, and you’ve rented it for the past 20 years while making improvements and repairs, as well as taking depreciation on it. Now it has a basis of $25,000 and a current market value of $250,000. Because you were an aggressive investor, you refinanced three times and now owe $200,000. If you sell this property for $250,000, your gain will be $225,000. Between state and federal taxes, you could have a tax liability of as much as $70,000. If you do some quick math, you’ll discover that to sell the property, you need to come up with $20,000 out of pocket.
You have just entered the investment world of exchanges. In a typical exchange, you would dispose of (sell) Property A and acquire Property B. As long as you follow the legal rules and use an accommodator—and Property B requires the same or more debt and the same or more equity as Property A—you can postpone paying taxes until sometime in the future.
What happens when you find Property B before you’re able to dispose of Property A? This is when you consider a reverse deferred exchange. It’s expensive and time consuming, but when faced with a $70,000 tax bill and $20,000 deficit, it could work well for you.
With a reverse deferred exchange, you purchase Property B before you sell Property A; actually, technically, your exchange accommodator buys Property B and holds it for you until you find a buyer for Property A, at which time the exchange is completed.
There are some incredibly strict rules with regard to the exchange: timelines and dates matter a lot. For example, you only have 45 days to identify the property to sell and 180 days to close escrow. The rules are so strict that 45 days and one hour is too long. And when I say 180 days, I do not mean 6 months. Just to add a little more complexity, there are additional limitations on those time frames if they cross calendar or fiscal year ends.
If you choose to undertake a reverse deferred exchange, all the complexity should be managed by your accountant, Realtor, accommodator, and title company. Your job is to pay the bill.
An accommodator’s standard fee for a standard transaction is about $500, but for a reverse deferred exchange, it’s closer to $5,000. Expensive? Yes. Far less than the $70,000 you’d pay otherwise? Also yes.
Financial challenges are one of the many pieces to this puzzle. You’ll need to come up with the down payment for Property B before you sell Property A. You’ll need to find a lender comfortable making a loan while the property is in the name of the accommodator. You’ll have to find an accommodator (ask your title company for a referral). These things take time, so don’t plan on a quick turnaround.
The good news is: you shouldn’t have to part with that $70,000.
If you have questions about real estate or property management, please contact me at firstname.lastname@example.org or call (707) 462-4000. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 40 years.