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. 

It's Not Too Late For Year-End Tax Planning With 1031 Exchanges

Those of you who are familiar with 1031 Tax Exchanges and perhaps have completed a number of them yourselves are probably wondering what this blog is all about.  You are probably asking yourselves "how can you possibly use a 1031 Tax Deferred Exchange for any kind of tax planning at year-end?"  The answer is actually quite simple. 

Failed 1031 Tax Deferred Exchange

1031 Tax Deferred Exchanges are all about tax planning.  The 1031 Exchange allows a real estate investor to sell rental or investment property and defer the payment of his or her taxes by structuring a 1031 Tax Exchange and buying like-kind replacement property. 

Year-End Tax Planning for Failed 1031 Exchanges

But, there are special year-end tax planning opportunities that come into play when you have a 1031 Exchange in progress and it fails.  In other words, you are not able to complete your 1031 Tax Deferred Exchange because you did not identify any replacement properties or you were not able to acquire any of the properties that you did identify.

Investor's Right to Receive 1031 Exchange Funds

The issue at hand when a 1031 Tax Deferred Exchange fails is when exactly is the sale of the relinquished property taxable since the 1031 Exchange failed?  The answer depends on many factors, including, and especially, when the investor actually has the right to receive or control or receive the benefits to his or her 1031 Exchange proceeds held by the Qualified Intermediary. 

Capital gains will be recognized in the year in which the investor has the right to receive his or her 1031 Exchange funds provided the 1031 Tax Deferred Exchange transaction and related 1031 Exchange documents and agreements were structured properly.  This means that the capital gain might be recognized in the following year rather than the year of sale under the right circumstances.