Year-End Tax Planning When a 1031 Exchange Fails
Failed Tax-Deferred Exchange May Qualify for Installment Sale Treatment
Investors often ask “what happens to my 1031 Exchange transaction if I sell my relinquished property and cannot find suitable like-kind replacement property to identify, or I cannot acquire the property that I did identify, within the prescribed 1031 Exchange deadlines?”
The advice generally rendered is that your 1031 Exchange has failed and will not qualify for tax deferred treatment; in short, it’s taxable. It may not be taxable immediately, however, depending on a number of factors.
It is possible that you could structure a partial 1031 Exchange or may be able to defer the capital gain tax consequences (but not depreciation recapture taxes) from the failed 1031 Exchange into the following income tax year. It will depend on your specific situation and fact pattern.
Build Your 1031 Exchange Technical Team In Advance
We always recommend that you choose a team of experts to help advise you while you are building your real estate investment portfolio. Your team should at least consist of an attorney with an emphasis in real estate (or perhaps tax), tax accountant, real estate broker, escrow officer that has experience with the type of property that you are involved with and a 1031 Exchange Qualified Intermediary with significant experience and expertise with the type of property that you are exchanging. This should help you avoid potential failed 1031 Exchanges or partial 1031 Exchanges.
Always Seek Advice of Counsel and Consider Back-up Strategies
It is extremely important that you consult with your legal, tax and financial advisors prior to entering into any 1031 Exchange. It is even more critical to immediately consult with the advisors when a 1031 Exchange appears likely to fail, especially at year-end.
It may be possible to save all or a portion of the tax-deferred benefits with the proper expert guidance and structure. You may also want to consider identifying and acquiring a beneficial interest in a Delaware Statutory Trust as a back-up investment strategy for your 1031 Exchange. There are generally numerous Delaware Statutory Trust investment opportunties available at any one point in time to choose from.
Partial Tax-Deferred Benefits
You can dispose of one or more relinquished properties and acquire one or more replacement properties as part of a single 1031 Exchange transaction. If multiple replacement properties are involved in the same 1031 Exchange transaction and not all of the replacement properties are acquired it may result in a partial 1031 Exchange.
Partial 1031 Exchanges mean that the investor either did not trade equal or up in value (i.e. they traded down in value) or they ended up with cash left over (i.e. cash boot) after completing their 1031 Exchange.
You should consult with your tax advisor to determine if completing a partial 1031 Exchange will still defer sufficient taxes in order to justify the 1031 Exchange. In many cases, a partial 1031 Exchange may still defer a portion of the depreciation recapture and/or capital gain income tax liabilities, unless you are trading too far down in value.
Installment Sale Treatment Under Section 453
In the case of a failed or partial 1031 Exchange transaction, you may be able to defer your capital gain income tax liability into the following income tax year rather than the current income tax year in which the relinquished property was sold (and closed).
You should not forget to take depreciation recapture into account. Income taxes due from depreciation recapture can not be deferred into the following income tax year and are due in the taxable year in which you sold (and closed on) your relinquished property.
It will depend on whether the 1031 Exchange Agreement used by the Qualified Intermediary for the 1031 Exchange transaction includes the required language contained in Section 1.1031 of the Department of the Treasury Regulations prohibiting the right to access your 1031 Exchange funds until the following income tax year.
The ability to defer the recognition and reporting of the taxable capital gain into the following income tax year depends on when you have the right to access or receive the benefit from your 1031 Exchange proceeds.
For example, if you dispose of your relinquished property as part of a 1031 Exchange and the relinquished property sale closes on December 1st of any taxable year, the 45 calendar day identification deadline and the 180 calendar day exchange period both land in the following income tax year.
If you did not identify any replacement property(ies) within the 45 calendar day identification period your capital gain income tax liability will be recognized in the following income tax year pursuant to the Installment Sale Rules under Section 453 of the Internal Revenue Code. This is because you did not have the legal right to access, or receive the benefits of, your 1031 Exchange funds until the 46th calendar day, which would be in the following income tax year.
Likewise, if you did not acquire some or all of your identified replacement property(ies) resulting in unused 1031 Exchange funds during the 180 calendar day exchange period, the capital gain income tax liabilities would also be recognized in the following income tax year pursuant to the Installment Sale Rules because you do not have the right to access, or receive the benefit of, the unused 1031 Exchange funds until after the 180th calendar day deadline has passed, which is also in the following income tax year.
You can also elect — at your sole discretion — to recognize and report the capital gain income tax liabilities in the current income tax year in which the relinquished property sold (and closed) instead of deferring it into the next income tax reporting year should you chose to do so. Do not forget that any depreciation recapture income tax liability would be taxable in the year in which the relinquished property was sold.
Structured Sale May Save a Failed 1031 Exchange
The Structured Sale can be integrated into your 1031 Exchange Agreements prior to the close of your relinquished property sale transaction. This integrated structure allows you to receive your 1031 Exchange proceeds in the form of a Structured Sale annuity contract instead of a taxable cash distribution in the event that your 1031 Exchange transaction should unexpectedly (or expectedly) fail.
The Structured Sale gives you the opportunity to continue to defer the payment of your capital gain taxes (but not depreciation recapture taxes) over a period of time that you choose even though your 1031 Exchange has failed. You still have control over when you pay your taxes.
Careful Planning Required
This short-term tax deferral strategy provides an excellent income tax planning opportunity when a 1031 Exchange transaction does in fact fail unexpectedly. However, there are numerous facts and actions that can affect the outcome of this short-term tax deferral strategy, so you should always have your advisors carefully evaluate the 1031 Exchange agreements and specific fact pattern involved with any failed 1031 Exchange transaction to determine when you had the right to access, or receive the benefits of, the 1031 Exchange funds in order to determine whether the capital gain income tax liabilities can be deferred into the following income tax reporting year. Careful planning is highly recommended when identifying like-kind replacement properties to ensure that you can take advantage of this short-term income tax planning opportunity should your 1031 Exchange fail.
Contact a senior 1031 Exchange advisor at Exeter 1031 Exchange Services, LLC or email your questions to ask@exeterco.com for more complete details.
