Why do 1031 exchanges fail?
Tax deferral is the goal of every 1031 exchange, but sometimes, despite the best efforts of exchangers and QIs, exchanges can fail. Often, this is because the exchanger doesn’t identify a suitable replacement property within the allowed 45-day window. Other times, an identified replacement property becomes unavailable, leaving the exchanger without options.
How can we mitigate the risk?
Even in the event of 1031 exchange failure, there are better and worse outcomes. If a property is sold and then the exchange fails in the same calendar year (2020, for example), the capital gain will be recognized in the year of the sale (2020) and the exchanger will need to pay the capital gains tax on their next tax due date (in 2021). But anytime an exchange process begins in one year and continues into another — thereby “straddling” the 1031 exchange over two tax years — the opportunity exists to treat the sale as an installment sale. This pushes the realized gain into the later year (2021), meaning the tax isn’t paid until the year after that — in this case, 2022.
The result is effectively a mini-deferral (for one additional year) of tax on the capital gain from the property sale. Put another way: timing your 1031 exchange carefully can result in a one-year “interest-free loan” from the government in the event of 1031 exchange failure.
How does it work?
This is not a tax shelter. “Tax straddling” is accomplished by shifting from IRC Section 1031 to another tax code section — IRC Section 453 — which allows a seller to defer recognition of a portion of the gain on the sale of an asset where at least one payment is to be received by the seller after the close of the taxable year in which the sale occurs.
Choosing a “tax straddling” window
To take advantage of this hedge on 1031 exchange failure, there are two windows of opportunity during which you should relinquish your property. The most straightforward is the period from November 17th through December 31st (the last 45 days of the tax year). If you relinquish property during this window, you don’t even need to identify replacement property to realize the tax straddling benefit. At the end of the 45-day period granted to identify replacement property, if you have not done so, you will realize the capital gain from the property sale — but by then it will already be a new tax year.
It’s also possible to benefit from “tax straddling” on property relinquished between July 5th and November 16th, but in this case you will need to identify replacement property — otherwise, the exchange will fail within the earlier tax year, and you will owe tax on your subsequent tax due date (just as if you had sold the property outright, rather than attempting a 1031 exchange).
Crucial considerations
One should never enter into a 1031 exchange if he or she ultimately desires to cash out of the investment. The 1031 exchanger must satisfy a “bona fide” intent-to-exchange requirement prior to being able to seek installment sale treatment through IRC Section 453. It is imperative that you confer with your CPA or attorney to ensure that your transaction is executed properly.
If you are required to make quarterly estimated tax payments, or if your tax-paying entity is classified as a partnership or corporation, it’s crucial that you discuss this approach with your CPA to assess your potential benefits. Cases in which tax straddling may not be permitted could result in the imposition of interest and/or late penalties.
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What can we help you exchange?
At JTC, we’ve put together an industry-leading track record of 1031 success, across tens of thousands of transactions and more than 25 years in the business. And we’ve built a cutting-edge administration platform, called eSTAC®, from the ground up to maximize your transaction security and transparency.
If you’re considering a real estate exchange, you’ve come to the right place. Talk to a JTC Representative today!
