The benefits of using a 1031 exchange when selling investment property are well known. But how do you maximize gain deferral when timing issues—like the end of a tax year—come into play? While there are some pitfalls to avoid when executing a 1031 exchange that straddles tax years, there are also some opportunities. Let’s examine the best way to handle a failed or partial exchange, maintain the full 180 days to find the perfect replacement property and receive an early release of remaining funds — all issues that arise when it’s time to turn the page on the year with a 1031 in process.
First, there is a way to preserve the full 180 days to purchase replacement property. Under the regulations, exchangers have 180 days or until their tax return due date, whichever comes first, to complete their exchange. If your relinquished sale closes between October 18th and December 31st and you file your return on April 15th, you will have less than the standard 180 days to close on replacement property and finish the exchange. (For example, if you sell your property on December 31st, you would have only 105 days to close out your exchange.) For exchangers who want or need the full time period, they have the option to file an extension of their tax return, which will allow them the full 180 days to acquire property. (If the taxpayer is a partnership, the tax return due date is March 15th, but can be similarly extended.) Additionally, if you file your tax return before the due date and have not yet closed on the replacement property, you will have a failed exchange. So when you are straddling tax years, the key is to acquire the replacement property before filing your return.
For example, Ryan sells an investment property on November 30th. He properly identifies property and has his sole replacement property under contract for a May 1st closing. He has two choices, the first of which is to negotiate an earlier closing that will occur before April 15th. If that is not possible, in order complete his exchange, Ryan must extend his return, purchase the replacement property and then file his taxes. Please note that if Ryan files his return on or before April 15 before closing on his replacement property, he invalidates his exchange and it fails.
Secondly, there may be tax reporting options available on failed exchanges when they straddle tax years. The first hurdle in an exchange is to identify potential replacement property within 45 days of the relinquished property closing. If an exchanger fails to identify property by this deadline, the exchange is considered to have failed and funds may be disbursed to the exchanger on the 46th day (see recent blog post). This is the first opportunity, according to the 1031 Regulations, that a taxpayer is allowed to receive funds directly from the Qualified Intermediary.
For taxpayers on calendar year reporting whose relinquished closing takes place between November 16th and December 31st, the end of their 45-day ID period will fall into the next tax year. If the exchange fails, then the sale takes place in one tax year, but the return and receipt of funds from a failed exchange occurs in a different tax year. The IRS allows taxpayers in this situation to report the gain in either the year of the sale or in the year the cash was received under the IRC 453 installment sale rules (see IRS Publication 537, Installment Sales.) Because some taxpayers have abused this rule, the IRS has added several conditions that govern the ability to choose between reporting years and how things must be reported.
Specifically:
1. Taxpayers must show a bona fide intent to complete an exchange — i.e. evidence that they did not set up the exchange solely to delay the tax consequences for one year.
2. If the amount of gain exceeds $5 million, then taxpayers could owe interest on the amount of tax liability.
3. If there was a loan repaid at the relinquished closing (called “mortgage boot”), then gain associated with this debt relief cannot be carried forward and must be recognized in the year of the sale.
An exchange may also fail when the taxpayer identifies property, but is unsuccessful in making any acquisitions. The Regulations require that under this scenario funds not be disbursed until the end of the exchange period, which is usually 180 days (with a few exceptions below). Failed or partial exchanges that start on July 5th or later will also straddle tax years because the 181st day will fall in the next tax year. The same applies for funds leftover from a “partial” exchange where property has been purchased, but not all the exchange proceeds were used, leaving a balance.
Finally, 1031s that straddle tax years can provide an opportunity for an earlier release of funds in failed or partial exchanges. If you identify property by day 45 and subsequently have either a failed or partial exchange, the balance of your exchange account cannot be disbursed to you until day 181. However, if your 1031 straddles tax years and the deadline for filing your tax return occurs within the allowed 180 day exchange period, then your exchange timeline is shorten to the day after that filing deadline. For example, Melanie and Robert sell their apartment complex on November 2, 2023 with their QI holding the $800,000 sale proceeds. Their 180-day exchange period ends on May 1, 2024. They identify property and put their favorite replacement property under contract. Unfortunately, the contract falls apart on January 15, 2024, and the two back up properties they also identified have already been sold. They can’t purchase any other properties because they are past their ID period, but they don’t want to wait until May 1st to get their exchange proceeds back. To expedite, they instruct their CPA to file their return on or before 4/15. Then, they forward proof to their QI that their return was filed which allows for their 1031 funds to be released to them on or after 4/16.
Remember, if your sale took place in the period from October 18 through December 31, 2023, you may use a tax filing extension to give yourself the full time allowed to complete your 1031 exchange. To get any remaining proceeds back sooner, don’t file an extension, just file the return on or before the normal deadline. Always check with your tax adviser before moving forward with these strategies.
