Year-End Tax Planning for Failed 1031 Exchanges

[Bill Exeter]

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, with in the prescribed 1031 exchange deadlines?”

The advice rendered is generally that your 1031 exchange has failed and will not qualify for tax deferred treatment; in short, it’s taxable. This may not be the case, however.

It is possible that the Investor could have a partial tax-deferred like-kind exchange or may be able to defer the income tax consequences from the failed 1031 exchange into the following income tax year. It will depend on the Investors specific situation.

Always Seek Advice of Counsel; Build Your Technical Team

We always recommend that Investors choose a team of experts to help advise them in building their real estate investment portfolio. The team should at least consist of a professional attorney, accountant, broker, escrow officer and Qualified Intermediary who are experts in the areas in which the Investor is working.

It is extremely important for Investors to consult with their legal, tax and financial team before entering into any tax-deferred like-kind exchange. It is even more critical to immediately consult with the advisors when a 1031 exchange appears likely to fail. It may be possible to save all or a portion of the tax-deferred benefits with the proper expert guidance.

Partial Tax-Deferred Benefits

Investors can dispose of one or more relinquished properties and can acquire one or more like-kind replacement properties as part of a single 1031 exchange transaction. If multiple like-kind replacement properties are involved in the same tax-deferred like-kind exchange transaction and not all of the replacement properties are acquired it results in a partial 1031 exchange.

Investors should consult with their tax advisor to determine if completing a partial tax-deferred like-kind exchange still makes sense. In many cases, a partial 1031 exchange may still defer a portion of the depreciation recapture and/or capital gain income tax liabilities, unless the Investor is trading too far down in value.

Installment Sale Treatment Under Section 453

In the case of a failed or partial tax-deferred like-kind exchange transaction, an Investor may be able to defer his capital gain income tax liability into the following income tax year rather than the income tax year in which the relinquished property closed.

Investors 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 the Investor disposed of (sold) his relinquished property.

It will depend on whether the Tax-Deferred Exchange Agreement used by the Qualified Intermediary for the Investor’s tax-deferred like-kind exchange transaction includes the required language contained in Section 1.1031 of the Department of the Treasury Regulations prohibiting access to the 1031 exchange funds until the following income tax year.

The ability to defer the recognition and reporting of the taxable gain into the following income tax year depends on when the Investor has the right to obtain access to or receive the benefit from his 1031 exchange funds.

For example, if an Investor disposes of his relinquished property as part of a 1031 exchange and the relinquished property disposition closes on December 1 of any taxable year, the 45 calendar day identification deadline and the 180 calendar day exchange period are both in the following income tax year.

If the Investor has not identified any like-kind replacement property within the 45 calendar day identification period the capital gain income tax liability would be recognized in the following income tax year pursuant to the Installment Sale Rules under Section 453 of the Internal Revenue Code because the Investor does not have the legal right to obtain access to or receive the benefits from his 1031 exchange funds until the 46th calendar day, which is in the following income tax reporting year.

Likewise, if the Investor did not acquire some or all of his like-kind replacement property(ies) that were identified 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 the Investor did not have the right to obtain access to or receive the benefit from the unused 1031 exchange funds until after the 180th calendar day deadline has passed, which is also in the following income tax reporting year.

The Investor can elect — at his sole discretion — to recognize and report the capital gain income tax liabilities in the income tax year in which the relinquished property closed instead of deferring it into the next income tax reporting year should he 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 disposed of.

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 the Investor should always have his technical advisors carefully evaluate the 1031 exchange agreements and specific fact pattern involved with any potentially failed 1031 exchange transaction to determine when the Investor had the right to obtain access to or receive the benefits from 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 the Investor can take advantage of this short-term income tax planning opportunity should his 1031 exchange fail.