What Happens if a 1031 Exchange Spans Two Tax Years?

Most taxpayers who are considering a Section 1031 exchange are familiar with the 45-day Section 1031(a)(3) and Section 1.1031(k)-1(c) provides that a written unambiguous description of the intended replacement property or properties, signed by the taxpayer must be sent to the qualified intermediary or other person who is a party to the exchange and who is not a disqualified person. Identification period, and the 180-day Exchange period. As a reminder, the taxpayer must identify the Replacement Property (or Properties) to be acquired within 45 days after the sale of the Relinquished Property. Section 1031(a)(3)(b) says that taxpayers must complete their 1031 exchanges within 180 days after the sale of their Relinquished Property, or the due date of their tax return, whichever is earlier. For most taxpayers, and in most years, the tax return due date is April 15 of the following year.

But for taxpayers who sell investment real estate in the fourth quarter as part of a 1031 exchange, it is imperative to pay particularly close attention to the exchange deadlines, specifically the rules and regulations around the 180 day exchange period. 

Realize Full Exchange Timeline by Filing for an Extension on Taxes

For example, if you sold your relinquished property after October 17, 2023, you must complete your 1031 exchange by April 15, 2024, or you must file for an extension on your 2023 taxes. This means that if you sold your investment property on November 30, 2023, for example, you would have an exchange deadline of April 15, 2024 – which is only 136 days later. To have the benefit of the full 180-day exchange period, you would have to file for an extension.

Filing for an extension on your tax return requires submission of Form 4868 and will provide you with a six-month extension on your income taxes. This does not, however, provide you with an additional six months to complete your 1031 exchange, but rather, the balance of your 180 days, which in November 30 example above, moves the deadline to May 29, 2024.

Convert Failed 1031 Exchange to Installment Sale

Alternatively, you could opt to let your exchange fail. Our November 30 example above has a 45-day identification deadline of January 14, 2024, and a 180-day exchange deadline of May 29, 2024. Whether the 1031 exchange fails by non-identification or by failure to acquire replacement property, you are not entitled to obtain the exchange proceeds until the subsequent tax year. In this example, the IRS allows you to either report the gain in the year of the sale, or in the year the proceeds were received under Section 453 installment sale rules. Choosing the installment sale rules would require you to file Form 6252, but effectively provides a one-year deferral on the gains from the sale of the property. Deciding to convert from a failed 1031 exchange to an installment sale does not result in any IRS penalties, and provides you with additional flexibility. Indeed, the default reporting of an unsuccessful exchange that crosses tax years is the installment sale method unless you affirmatively choose to report it in the prior year.

Keep in mind that the rules for Section 453 installment sales are quite specific. Installment sales do not necessarily apply to all sales, and do not defer any gain that was attributable to debt relief. (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s are strongly encouraged to discuss the concepts covered here with their tax and/or legal advisors.

Implications of a Partial Exchange

There is yet another possible scenario. Assume that you sold your relinquished property on November 30, 2023 for $500,000 as part of a properly structured 1031 exchange. Your 45-day identification deadline is January 14, 2024 and your 180-day acquisition deadline is May 28, 2024. You properly identify one target replacement property before the deadline, and ultimately acquire that property on January 30, 2024 for $450,000. This results in “boot” – taxable event – of $50,000. Whether this $50,000 is attributable to depreciation recapture or capital gains, the results are the same, you could elect to recognize the taxable event on your 2023 tax return, or you could elect installment sale treatment as discussed above.

Whether you should recognize the taxable event in 2023 or 2024 is a taxpayer specific inquiry that is best resolved by consulting your tax and legal advisors.

*Updated 12/29/2023.