Tax Planning When A Tax Deferred Exchange Fails at Year-End

What happens when you start a Tax Deferred Exchange transaction, but you are unable to acquire any of the replacement properties that you identified within the prescribed Tax Deferred Exchange deadlines?  The bad news is your Tax Deferred Exchange is now taxable. The good news is your Tax Deferred Exchange may not be immediately taxable.

It is possible to defer all or some of your taxable gain into the following income tax year even with a failed Tax Deferred Exchange transaction.  It will, of course, depend upon the individual facts and circumstances in your specific Tax Deferred Exchange transaction.  It is critical that you consult with your Tax Deferred Exchange Qualified Intermediary and your income tax advisor when your Tax Deferred Exchange transactions appears to be headed for failure.  

Partial Tax Deferred Exchange

For example, if multiple identified replacement properties are part of the same Tax Deferred Exchange but not all of the replacement properties will or can be acquired, it can result in a partial Tax Deferred Exchange.  Partial Tax Deferred Exchanges can mean that you have traded down in value or have exchange proceeds that were not use and are left over from the sale of your relinquished property.  Partial Tax Deferred Exchange transactions can still defer part of your taxable gain in certain circumstances.  

Installment Sale Treatment Under Section 453 

Section Numbers 1031 and 453 of the Internal Revenue Code ("Code") work in conjunction with each other and can provide significant benefits even when a Tax Deferred Exchange fails.  You may be able to defer all or part of your taxable gain from a failed or partial Tax Deferred Exchange into the following tax year rather than the current tax year under Section 453 (Installment Sale Code).  It will depend on whether your Tax Deferred Exchange Agreement includes language prohibiting your right to access your Tax Deferred Exchange funds until the following income tax year.

For example, if you dispose of your relinquished property as part of a Tax Deferred Exchange and the relinquished property sale closes on December 1st of a specific taxable year, the 45th calendar day identification deadline and the 180th 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 taxable gain will be recognized in the following tax year because you did not have the legal right to access your Tax Deferred 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) 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 Tax Deferred 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 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. 

Is It Better To Sell My Relinquished Property in 2009 Or Postpone Until 2010

Taxpayers have only four more business days to get transactions structured and closed until 2010 hits us right between the eyes.  First of all, yikes, where did 2009 go?  Second of all, thank God we are moving into 2010, which promises to be a much better year than 2009.

Closing By Year-End

Now to the question of when to close on the sale of your relinquished property.  It has always boggled my mind during the 24 years that I have been in the 1031 Exchange industry that so many taxpayers want to close on their relinquished property before year-end when they are structuring a 1031 Tax Deferred Exchange. 

Why put so much pressure on yourselves?  Its a tax-deferred exchange, so its tax deferred and it shouldn't matter when you close on the sale of your property assuming that all other relevant factors are equal.  However, let's discuss some of the basic reasons why, and then get to the question. 

The Buyer

Certainly, the buyer may wish to close by December 31st in order to obtain any number of benefits, including tax benefits, of owning the property before year-end.  The tax benefits can often be tremendous, or losing tax benefits that may expire at year-end may be very expensive.  So, the buyer may have motives for doing so. 

There may be other reasons as well, such as deploying investment capital by year-end, shoring up the balance sheet ("window dressing") for year-end financial statements, etc. 

The Seller

Generally, the seller completing the 1031 Tax Exchange shouldn't care, but some of the same reasons my apply.  They may want to get the property off their balance sheets by year-end, may want to reduce the amount of outstanding debt before December 31st, etc., just to name a few of the more obvious reasons. 

When to Sell/Close

One or both parties may wish to close on the property for some of the reasons stated above, or other reasons, in which case, it certainly does make sense to sell and close on the property before December 31st. 

However, barring other benefits, detriments, or issues not mentioned here, there is no real benefit from a 1031 Exchange perspective to closing in 2009 or 2010, unless you are concerned that your 1031 Tax Exchange may fail (i.e. you are not able to acquire replacement property). 

A failed or incomplete 1031 Exchange is generally taxable in the year of sale or the year in which the taxpayer has the right to receive their 1031 Exchange proceeds from the Qualified Intermediary.  This is the one main issue that taxpayers should consider when selling relinquished property in order to answer the question when should they close because it may affect their income tax situation. 

As yourself the following questions:

• Will closing in 2009 versus 2010, or vice versa, potentially place myself in a higher income tax bracket because of the 1031 Tax Deferred Exchange?
• Will closing in 2009 trigger my 45 day and 180 day deadlines before I am ready to?
• Would closing in 2010 buy me more time to look for and identify suitable replacement properties to be acquired through my 1031 Exchange? 
• Will closing earlier or later help or hurt my borrowing position? 
• Will closing in 2009 hold up the filing of my income tax return if I have not completed the acquisition of my replacement property?

There are probably many more question like this that should be addressed, so you should always consult with your legal and tax advisors before proceeding with your 1031 Tax Deferred Exchange. 

Can I Change the Property that I have Identified in My 1031 Exchange

The 1031 exchange requires that you sell an exchange property (relinquished property) and acquire other property (replacement property in order to defer the payment of your capital gain taxes.

Replacement Property Identification
The 1031 exchange process requires that you identify the replacement property or properties that yu are going to acquire as your replacement property within your 1031 exchange. The identification must be made within 45 days from the date that you sold and closed on the sale of your exchange or relinquished property.

Changing Identified Property
The question that comes up all the time is can I change the replacement properties that I have already identified as part of my 1031 exchange. The answer is: It depends.

You can change your mind and revoke your identified properties at any time as long as you are still within your 45 calendar day identification period. Simply contact your 1031 exchange Qualified Intermediary and find out how they want you to revoke the identification that you already provided them with. I would recommend that you make a complete revocation of your previous identification even if you do not want to revoke all of the properties and then make a completely new identification on a separate identication form. This keeps the entire process nice and clean.

However, you can not change your mind and revoke your replacement property identification if you are outside of your 45 day identification period. You can only change your mind during the 45 day ID period, but not after the 45 ID period has past.

Beware of Changing Your Mind After the 45 Day Period
There are those 1031 exchange Qualified Intermediaries that allow you to amend, alter or change your identification period after the 45 day period. I get the comment all the time: It doesn't matter; THEY let me do it. Actually, they are allowing YOU to commit TAX FRAUD. I know that it is tempting, but it is tax fraud none the less.

How Can I Get An Extension For My 45 Day ID Period?

I hear this question virtually each and everyday. It's usually in a state of panic because the 1031 exchange investor is running out of time to identify his or her replacement property.

The 45 calendar day deadline to identify replacement property is a very short period of time and can be difficult, so 1031 exchange clients should start looking for replacement properties as soon as they know they are going to sell and structure a 1031 exchange.

Tax Deferred Exchange Due Dates Are Law; Not Regulations

Unfortunately, there is no way to get an extention of time for your 1031 exchange deadlines or due dates, unless you or the subject property is affected by a natural disaster such as a fire, flood, hurricane, etc.

The 1031 exchange deadlines or due dates are actually part of the tax code (laws) and are not part of the IRS Regulations (i.e. Section 1031 of the Internal Revenue Code), and can not be extended without an act of Congress. The IRS does not even have the ability to grant an extension, alter or postpone the 45 or 180 calendar day deadlines.