Year-End Bonus – The Potential for Short-Term Tax Deferral in a Failed 1031 Exchange
Savvy real estate investors appreciate the benefits of Internal Revenue Code Section 1031. This provision allows taxpayers to exchange property that’s held for investment, or used in a trade or business, for other like-kind property and defer recognition of the gain on the sale of the relinquished property.
As required by the Treasury Regulations, the proceeds from a sale are entrusted to a Qualified Intermediary and held in a qualified escrow or qualified trust account. The account is “qualified” only if the taxpayer’s right to receive the cash is restricted in accordance with the provisions described at Reg. 1.1031(k)-(1)(g)(6), commonly referred to as the “(g)(6)” restrictions. If the taxpayer has control over the cash, the transaction will be deemed a sale, not an exchange.
The first instance where the cash can be released to a taxpayer is day 46 following the transfer of the relinquished property. If, as of the end of the 45-day identification period, no replacement property is identified, the taxpayer may receive the cash from the Qualified Intermediary on day 46 or any time thereafter.
On occasion, these transactions cannot be completed timely and a taxpayer is forced to recognize the gain. If the exchange period crosses a tax year end, when is the gain reported and recognized?
Consider the following scenario:
Mr. Smith sells a residential rental property for $2 million on December 3, 2014 and enters into a 1031 exchange. The $2 million is deposited into a qualified trust account. Mr. Smith then sets out to find replacement property. He calls his broker, views several online listings, and writes an offer of $2.5 million on a multi-family property that’s listed at $3.1 million. Mr. Smith’s offer is rejected, and he ultimately decides he will not formally identify any potential replacement properties. The cash from the sale of Mr. Smith’s relinquished property is paid to him from the qualified trust on January 18, 2015 (day 46). Mr. Smith will report the sale on his 2014 return and recognize the gain on his 2015 return.
This one year deferral is the result of Treasury Regulations under IRC Section 1031, which includes a provision permitting taxpayers to use the installment sale method under IRC Section 453 when failed (or partial) exchanges straddle tax years. This will allow taxpayers to recognize gains from the sales in year two when the exchange fails, and funds are received from the Qualified Intermediary.
However, a few points warrant mention:
First, taxpayers must demonstrate a bona fide intent to enter into an exchange at the beginning of the exchange period. A taxpayer is treated as having a bona fide intent only of it’s reasonable to believe, based on all of the facts and circumstances as of the beginning of the exchange period, that like-kind property will be acquired before the end of the exchange period. At a minimum, the proceeds of sale must be held in the qualified trust or escrow account for the full 45-day identification period before an exchange can be treated as failed.
Second, IRC Section 453A provides that, in the case of an installment sale obligation: (1) where an obligation is outstanding as of the close of the taxable year, and (2) the face amount of all such obligations held by the taxpayer that arose during, and are outstanding as of the close of, such taxable year, exceeds $5 million, interest must be paid on the deferred tax liability with respect to such obligation(s). We suggest you consult your tax advisor or IRS Publication 537, Installment Sales, for additional information on this provision.
Finally, pushing the gain into the next taxable year may not be ideal for all taxpayers. The potential interest liability referred to above may be significant, or there may be losses available to offset the gain in the current year. It is always a good exercise to examine the economics of the transaction prior to committing to a specific course of action.
Still, delaying the tax bite until next year can be a powerful planning tool and shouldn’t be overlooked when the numbers make sense.