Since 1921, sellers of real estate have been able to defer taxable gains under Internal Revenue Code (IRC) Section 1031, commonly known as a like-kind exchange. When a taxpayer engages in a like-kind exchange of property, which is a tax-deferred transaction in which one investment property is exchanged for another of the same type, they may defer recognition of any gain or loss realized on the exchange.
However, if the exchange fails and the taxpayer receives cash or other non-like-kind property, the taxpayer may be subject to immediate recognition of any gain or loss realized on the exchange. If the taxpayer fails to complete their Section 1031 exchange, the installment method can allow them to defer paying capital gain taxes from the sale of an investment property.
Recognition of Gain or Loss
When a taxpayer sells property within 180 days of the end of the year, the like-kind exchange is not required to be completed before the end of the year. A qualified intermediary (QI), often times the closing attorney, holds the proceeds from the sale during the period before the replacement property is purchased. In this case, the proceeds from the sale would not be released from the QI to the taxpayer until the subsequent year.
If the seller does not find a like-kind replacement property within the required time frame, it becomes a failed 1031 exchange. In the case of a failed exchange, the seller may consider structing the sale as an installment sale. Under the installment method, gains from a sale are recognized in the year cash is received by a taxpayer. Because the QI, and not the taxpayer, held the cash during the 180-day period, the taxpayer is considered to receive the cash when it is released from the QI.
The installment method is only available to taxpayers who make a bona fide attempt complete the like-kind exchange. The installment method is not available when there was no intention of purchasing replacement property.
Advantages of an Installment Sale
Restructuring a failed exchange into an installment sale has potential benefits beyond tax deferment. The seller may have more flexibility concerning how the proceeds of the sale are used or be able to use the funds for another purpose.
The installment method can also help reduce the risk of losing the sale if they are unable to find a replacement property, which is a potential with 1031 exchanges. Since the installment structure has no specific time frame limits in which sellers must acquire a replacement, a seller can potentially defer capital gains.
Timing of Recognition
The timing of recognition is an important rule to keep in mind, as it can have significant tax implications for the taxpayer. If the taxpayer receives non-like-kind property or cash in the same tax year as the failed exchange, they must report any gain or loss realized on the exchange on their tax return for that year. This could result in a higher tax liability for the taxpayer in that year.
However, if the taxpayer receives non-like-kind property or cash in a subsequent tax year, they may be able to defer the recognition of gain or loss on the failed exchange until that year. This could potentially reduce the taxpayer’s tax liability in the year of the failed exchange, as they would not have to recognize the gain or loss until a later year.
It is important for taxpayers to understand the timing rules for recognizing gain or loss on a failed like-kind exchange and to properly report the transaction on their tax return. Failure to report the gain or loss in the correct tax year could result in penalties and interest charges.
Basis of New Property
Another important rule to consider when a taxpayer experiences a failed like-kind exchange is the basis of the new property received. Generally, the basis of the non-like-kind property received is its fair market value at the time of receipt. This means that if the taxpayer receives cash or a non-like-kind asset in exchange for their relinquished property, the basis of the new property is the fair market value of that property at the time of receipt.
In case the taxpayer takes on a liability related to the exchange, such liability is deemed a part of the purchase price of the new property, and as a result, the basis is adjusted accordingly. For instance, if the taxpayer assumes a mortgage on the new property as part of the exchange, the basis of the new property would increase by the amount of the mortgage assumed.
Failing to complete a like-kind exchange is not ideal, but utilizing the installment method can help avoid worst-case outcomes and provide taxpayers an option that may allow for other planning opportunities. To help ensure the installment method is allowed by the IRS, taxpayers should retain documentation to support their intention and efforts to purchase replacement property. Support could include emails to real estate agents or signed letters of intent to purchase identified property. Documentation supporting why the purchase failed should also be retained.
Let Us Guide You Forward
Our Real Estate & Construction tax professionals have extensive experience helping clients navigate the complexities of tax laws and regulations surrounding real estate investments. Taxpayers who have experienced a failed like-kind exchange should consult with a tax professional to ensure proper reporting and maximize their tax benefits while minimizing their tax liabilities.
Properly reporting the tax implications of a failed like-kind exchange is vital to avoid potential penalties and interest charges. We can help you understand the rules and limitations of the installment method, as well as the timing of recognition, so you are prepared to effectively manage tax liability in the event of a failed exchange.
