Is Your 1031 Exchange Straddling Two Tax Years?

Most users of Section 1031 understand the 180-calendar day deadline to complete their like-kind exchange.  This general understanding of the exchange period deadline is fine for most transactions, but many exchangers remain unaware of the more nuanced definition of this critical period.

What do the regulations say?

Section 1031’s underlying regulations state, “The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.”

What do the regulations mean?

The regulations generally allow for 180 calendar days for taxpayers to complete their like-kind exchange transactions.  However, individual taxpayers that began a 1031 exchange after October 19 of this current year must understand the exchange period does not guarantee a full 180 days.  The bottom line is that individuals who are unable to purchase replacement property by April 17 should consider filing a tax extension to give themselves the full 180 days.  Like-kind exchanges that begin late in the year can also trigger special reporting considerations. 

Reporting the Transaction

After completing the exchange (purchasing the replacement property), taxpayers will report the transaction on Form 8824, Like-Kind Exchanges.  Form 8824 is prepared and filed in the same tax reporting year in which the relinquished property was transferred/sold.

For failed 1031 exchanges that straddle tax years, taxpayers may seek installment tax reporting on IRS Form 6252 in the year of the relinquished property sale.  For instance, if the relinquished property closed between November 16 and December 31, the 45-day identification would be in the following calendar year.  Similarly, if the relinquished property closed after July 5, and potential replacement property was identified within the 45-day identification period but no replacement property was actually acquired, the end of the exchange period would be in the following calendar year.  If the 1031 exchange fails by non-identification or by failure to purchase a replacement property, the sale proceeds would be returned to the exchanger in a different tax reporting year.  In this circumstance, the IRS allows taxpayers to either report the gain in the year of sale or in the year the proceeds were received under IRC 453 installment sale rules.  This would allow the taxpayer to select the year of reporting that is most beneficial.  One might say that a year’s worth of tax deferral is available regardless of the exchange having failed.

Taxpayers Beware

Installment sale treatment generally requires a bona fide intent to complete an exchange.  This means that the taxpayer had reason to believe, based on the facts and circumstances at the beginning of the exchange, that a like-kind replacement property would be acquired during the exchange period.
Other installment sale issues:

1. If there was debt paid off at closing of the relinquished property and gain associated with this debt, relief is generally recognized in the year of sale. 
2. The gradual reduction in value of an asset over time. The IRS requires investors to depreciate real estate (and certain other assets) over a specified period of time. Residential real estate uses a 27.5 year schedule, and commercial real estate uses a 39 year schedule. Depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale.
3. A charge paid by a borrower to a lender for the opportunity to borrow funds via a loan or the funds earned by an account owner/beneficiary on the amount held on deposit. Interest is charged on the tax deferred if the sale price of the relinquished property is over $150,000 and certain other instalment obligations exceed $5 million.

For taxpayers who have a taxable gain, there is one additional issue to consider.  If you are unsettled about current tax rates, you may extend your tax return to report by October 15.  This way, you can wait and see if the Congress will change the rates and select the year of reporting that is most beneficial for you.
Check with your tax advisor to determine the correct tax forms and tax extensions to utilize along with the selection of the reporting year for your exchange.