A 1031 Exchange, named after the section in Internal Revenue Service code that governs it, is when a property owner disposes of one property to purchase another and does so without incurring a Capital Gains Tax. In the traditional 1031 Exchange a person must sell a property and identify a different, 'like kind' , property to purchase within an established period of time. A 1031 exchange offers real estate investors one of the best tax strategies for preserving the value of an investment portfolio and building wealth.
In addition, on September 15, 2000, the IRS released Revenue Procedure 2000-37, which created an approved "safe harbor" for “Parking” or “Reverse” exchanges. In such an exchange, an investor acquires a replacement property before disposing of the property they will exchange it for.
Some of the reasons an investor would consider a Reverse Exchange are:
- An investor has the opportunity to purchase an exceptional Replacement Property at a good price or one that fits a particular need but the transaction must close quickly, before the property they are exchanging can be sold).
- The transaction closing on the property being sold falls apart at the last minute and the replacement property closing is impending.
- The closing date on the property being sold cannot be extended and the investor faces potential loss of his earnest money deposit on the replacement property.
- Remodeling or construction must be completed to increase the value of the replacement property to a level that complies with IRS rules governing 1031 Exchanges.
- The investor’s need to gain more time to negotiate an acceptable price for the relinquished property and still acquire the desired replacement property.
- The vehicle that owns the relinquished property is structured as a partnership or LLC and must be restructured as a tenancy-in-common arrangement to meet the investor’s goals, but closing on the replacement property cannot be delayed.
- Extreme market conditions.
- Large capital gains tax liability.