When considering the sale and replacement of commercial or investment property, it might be wise to look into a reverse exchange. This method of property exchange, also known as a 1031 reverse exchange or as a reverse 1031 exchange, is a result of Revenue Procedure 2000-37, a federal tax statute enacted in the U.S. in September of 2000.
A 1031 exchange is a “safe harbor” established by the IRS to allow for circumstances that would permit taxpayers to take advantage of a financially attractive and potentially profitable opportunity to purchase new and sell old investment or commercial property. A 1031 exchange covers a number of property transactions besides reverse exchanges. Real estate, by far the most commonly exchanged commodity, may include office buildings, warehouses, apartment buildings, etc. Undeveloped land may also be included in a 1031 reverse exchange as long as the lot is in a properly zoned area.
Essentially, a 1031 reverse exchange transaction is the method whereby the purchase of the replacement property by an individual or a consortium before the sale of the relinquished property is accomplished and without adverse tax effects. The recognized gain or loss of such a transaction by the Internal Revenue Service (IRS) is deferred indefinitely, assuming all terms, conditions, and time limits of the exchange are met. This property transfer option represents a legal avoidance of what is often a substantial capital gains tax. The replacement property must, however, be of equal or greater value than the relinquished property.
In a reverse exchange, the title or deed to either the replacement property or the relinquished property is, for a fee, “parked” or held by an accredited Exchange Accommodation Title-holder (EAT) for up to 180 days. After that time, if the relinquished property has not sold, the 1031 reverse exchange transaction may be voided and any capital gains resulting from the transaction are recognized and taxed. A 1031 reverse exchange that takes longer than 180 days, for example a property under construction or renovation, may be accomplished but an IRS audit may refuse the transaction. Purchasers of the replacement property may re-transact another 1031 reverse exchange if it is determined that the relinquished property is not going to sell within the 180 day time frame. Again, however the IRS may or may not recognize such further exchange transactions.
While any type of commercial or investment property may be given a safe harbor using a 1031 exchange, the most common is real estate since it is most often subject to capital gains recognition by the IRS.