THE 1031 EXCHANGE INSTITUTE

Taxpayers frequently have this question for tax advisors each and every tax year:

What happens to my 1031 Exchange transaction if I sell my relinquished property and cannot find suitable like-kind replacement property to identify, or I cannot acquire the replacement property that I did actually identify with in the prescribed 1031 exchange deadlines?

General Advice: It Fails and is Now Taxable

The advice generally provided by many professional tax advisors at this point in time is that since the taxpayer was not able to complete his or her 1031 Exchange and it has technically failed it will no longer qualify for tax deferred treatment under Section 1031 of the Internal Revenue Code.  In other words, it is now a taxable sale of real estate this year rather than a tax deferred exchange of real estate.

I posted an extensive article on this point last year as well, but thought a reminder was in order as re approach the end of 2009. The question at hand is when exactly is a taxpayer's failed 1031 Exchange taxable? 

Failed 1031 Exchanges May Be Taxable in 2009 or 2010

The technically correct answer is that it depends!  This is one of my most favorite answers to many 1031 Exchange related questions and issues as those of you who have attended my webinars and seminars know. 

There are a number of questions that must be asked regarding the failed 1031 Exchange in order to determine whether it will be taxable this year when the sale of the real property actually occurred, taxable next year when the 1031 Exchange proceeds were actually received by the taxpayer, or taxable well into the future as an installment sale arrangement. 

The answer is not as easy as it may seem.  It is not merely dependent upon when the taxpayer actually received his or her 1031 Exchange proceeds from his or her 1031 Exchange Qualified Intermediary, but rather when he or she had the "right" to receive their 1031 Exchange funds.  

The failed 1031 Exchange may actually not be taxable immediately in the year of sale as many tax advisors often indicate.  The taxpayer's failed 1031 Exchange may still qualify for tax deferred treatment under Section 453 like an installment sale contract ("seller carry back note" or "Deferred Sales Trust").

It is possible that the taxpayer could have a partial 1031 Exchange or may be able to defer the income tax consequences from the failed 1031 Exchange into the following income tax year. It is also possible that the taxpayer could defer his or her capital gain liability well into the future if their 1031 Exchange Agreement included language that provided for the option to receive their failed 1031 Exchange funds via a Deferred Sales Trust.  So, it will depend on the taxpayer's specific situation.

Always Seek Advice of Counsel; Build Your Technical Team

We always recommend that taxpayers choose a team of experts to help advise them in building their real estate investment portfolio.  The team should at least consist of a real estate attorney, tax accountant, real estate broker, escrow officer and Qualified Intermediary who are experts in the areas in which the taxpayer plans to invest in.

It is extremely important for taxpayers to consult with their legal, tax and financial team before entering into any 1031 Exchange.  It is even more critical to immediately consult with their advisors when a 1031 Exchange appears likely to fail to qualify for tax deferred exchange treatment.  It may be possible to save all or a portion of the tax-deferred benefits with the proper planning.

Partial Tax-Deferral Benefits

Taxpayers can dispose of one or more relinquished properties and can acquire one or more like-kind replacement properties as part of a single 1031 Exchange transaction.  If multiple like-kind replacement properties are involved in the same 1031 Exchange transaction and not all of the replacement properties are acquired it results in a partial 1031 Exchange.

Taxpayers should consult with their tax advisor to determine if completing a partial 1031 Exchange still makes sense.  In many cases, a partial 1031 Exchange may still defer a portion of the depreciation recapture and/or capital gain income tax liabilities, unless the taxpayer is trading too far down in value.

Installment Sale Treatment Under Section 453 of the Internal Revenue Code

In the case of a failed or partial 1031 Exchange transaction, a taxpayer may be able to defer his capital gain income tax liability into the following income tax year or beyond rather than the income tax year in which the relinquished property closed.

Taxpayers should not forget to take depreciation recapture into account.  Income taxes due from depreciation recapture can not be deferred into the following income tax year and are due in the taxable year in which the taxpayer disposed of (sold) his relinquished property.

The ability to defer taxes when a 1031 Exchange fails will depend on whether the 1031 Exchange Agreement used by the Qualified Intermediary for the taxpayer's 1031 Exchange transaction includes the required language contained in Section 1.1031 of the Department of the Treasury Regulations prohibiting access to the 1031 Exchange funds until the following income tax year.

The ability to defer the recognition and reporting of the taxable gain into the following income tax year depends on when the taxpayer has the right to obtain access to or receive the benefit from his or her 1031 Exchange funds.

For example, if the taxpayer disposes of his or her relinquished property as part of a 1031 Exchange and the relinquished property disposition closes on December 1 of any taxable year, the 45 calendar day identification deadline and the 180 calendar day exchange period both land in the following income tax year. 

If the taxpayer has not identified any like-kind replacement property within the 45 calendar day identification period the capital gain income tax liability would be recognized in the following income tax year pursuant to the Installment Sale Rules under Section 453 of the Internal Revenue Code because the taxpayer does not have the legal right to obtain access to or receive the benefits from his 1031 Exchange funds until the 46th calendar day, which is in the following income tax reporting year.

Likewise, if the taxpayer did not acquire some or all of his like-kind replacement property(ies) that were identified resulting in unused 1031 Exchange funds during the 180 calendar day exchange period, the capital gain income tax liabilities would also be recognized in the following income tax year pursuant to the Installment Sale Rules because the taxpayer did not have the right to obtain access to or receive the benefit from the unused 1031 Exchange funds until after the 180th calendar day deadline has passed, which is also in the following income tax reporting year.

The taxpayer can elect - at his or her sole discretion - to recognize and report the capital gain income tax liabilities in the income tax year in which the relinquished property closed instead of deferring it into the next income tax reporting year should he chose to do so.  Do not forget that any depreciation recapture income tax liability would be taxable in the year in which the relinquished property was disposed of.

Deferred Sales Trust Election

The taxpayer can also defer his or her capital gain tax liability well into the future when his or her 1031 Exchange fails if the 1031 Exchange Agreement integrated the property language allowing the taxpayer to elect to receive his or her 1031 Exchange proceeds via a Deferred Sales Trust if the 1031 Exchange were to fail.  This election must be made up front prior to the close of the relinquished property. 

Careful Planning Required

This short-term tax deferral strategy provides an excellent income tax planning opportunity when a 1031 Exchange transaction does in fact fail unexpectedly.  However, there are numerous facts and actions that can affect the outcome of this short-term tax deferral strategy, so the taxpayer must always have his technical advisors carefully evaluate the 1031 Exchange Agreements and specific fact patterns involved with any potentially failed 1031 Exchange transaction to determine when the taxpayer actually had the right to obtain access to or receive the benefits from the 1031 Exchange funds in order to determine whether the capital gain income tax liabilities can be deferred into the following income tax reporting year or beyond. 

Careful planning is highly recommended when identifying like-kind replacement properties to ensure the Investor can take advantage of this short-term income tax planning opportunity should his 1031 exchange fail.

Contact a senior 1031 exchange advisor at Exeter 1031 Exchange Services, LLC or Exeter Fiduciary Services, LLC for more information regarding year-end planning opportunities with failed 1031 Exchanges and/or Deferred Sales Trusts.