Failed 1031 Exchanges: Year-End Planning

You do your due diligence, select your Qualified Intermediary and open your 1031 Exchange account (refer to blog post on Qualified Intermediaries Are Not Created Equal for what to look for when selecting a Qualified Intermediary).  You sell and close on the sale of your relinquished property.  Your Qualified Intermediary is now holding your 1031 Exchange funds from the sale of your relinquished property in a separate, segregated dual-signature Qualified Trust Account in order to protect your funds.

Failed 1031 Exchange

What if you are not able to complete your 1031 Exchange?  What if you can't acquire all or any of the of the replacement properties that you identified within your 45 calendar day identification period? 

Here is the bad news. Your 1031 Exchange has either partially or completely failed and is now reported as a taxable sale transaction.  However, the good news is that the Failed 1031 Exchange may not be immediately taxable.  It is possible to defer all or some of your taxable gain into the following income tax year under Section 453 of the Internal Revenue Code.  

Your ability to defer your taxable gain into the next tax year will depend upon the individual facts and circumstances involved in your specific 1031 Exchange.  You should immediately consult with your Qualified Intermediary and your tax advisor when you suspect that your Exchange transactions appears to be headed for failure.

Partial 1031 Exchange

If multiple replacement properties are part of the same 1031 Exchange but not all of the replacement properties will or can be acquired, it can result in a partial 1031 Exchange. Partial 1031 Exchanges mean you have traded down in value or have 1031 Exchange funds left over from the sale of your relinquished property. Partial 1031 Exchange transactions may still allow you to defer part of your taxable gain depending how how much you have traded down in value or how much 1031 Exchange funds were not reinvested.  

Failed or Partial 1031 Exchanges May Qualify For Installment Sale Treatment

Section 1031 of the Internal Revenue Code ("1031 Exchange") and Section 453 of the Internal Revenue Code ("Installment Sale") work in conjunction with each other and can provide significant benefits even when a 1031 Exchange transaction fails. 

You may be able to defer all or part of your taxable gain from a failed or partial 1031 Exchange into the following tax year rather than the current tax year under the installment sale rules. It will depend on whether your 1031 Exchange agreement includes the proper language from the Treasury Regulations prohibiting your right to access, or received the benefit from, your 1031 Exchange funds until the following tax year.

For example, if you close on the sale of your relinquished property as part of a 1031 Exchange and on December 1st of a specific tax year, the 45th calendar day identification deadline and the 180th calendar day exchange period both land (end) in the following tax year.

If you did not identify any replacement property(ies) within the 45 calendar day identification period, your taxable gain will be recognized in the following tax year because you did not have the right to access your 1031 Exchange funds until the 46th calendar day, which would be in the following income tax year (assuming the proper language was included in your 1031 Exchange agreement). 

Likewise, if you did not acquire some or all of your identified replacement property(ies) during the 180 calendar day exchange period, your taxable gain would be recognized in the following tax year because you did not have the right to access your 1031 Exchange funds until after the 180th calendar day deadline has passed, which is also in the following tax year (also assuming the proper language was included in your 1031 Exchange agreement).

You can also choose — at your sole discretion — to recognize and report the taxable gain in the current tax year in which the relinquished property sold instead of deferring it into the next tax year should you chose to do so.