Year-End Tax Planning When a 1031 Exchange Fails

Despite the best intentions, taxpayers routinely fail to complete 1031 exchanges. One reason for such missteps may be attributable to, or at least exacerbated by, the cottage industry spawned by 1031. Numerous exchange facilitators, intermediaries, escrow companies, and others of similar ilk utilize 1031 as their bread and butter; some are more cautious than others, but mistakes do occur.

This article does not focus on how a deferred exchange can fail, but rather on the implications of an exchange agreement which states that a seller must complete a structured sale if the parties fail to close in compliance with 1031. Moreover, the article considers whether a taxpayer who has not met the requirements of 1031 can defer gain under 453 by undertaking a transaction in a structured sale.

If an Investor’s 1031 Exchange has failed, it will not qualify for tax deferred treatment; in short, it’s taxable.  It may not be taxable immediately, however, depending on a number of factors. It is possible that an Investor could structure a partial 1031 Exchange or may be able to defer the capital gain tax consequences from the failed 1031 Exchange into the following income tax year.  It will depend on your specific situation and fact pattern.

An Investor can dispose of one or more relinquished properties and acquire one or more replacement properties as part of a single 1031 Exchange transaction.  If multiple replacement properties are involved in the same 1031 Exchange transaction and not all of the replacement properties are acquired it may result in a partial 1031 Exchange. Partial 1031 Exchanges mean that the investor either did not trade equal or up in value or they ended up with cash left over after completing their 1031 Exchange.

The growth of the 1031 exchange industry speaks volumes for the tax benefits of exchanges, and perhaps for the fascination taxpayers have for rolling their gain into replacement property. Still, undertaking a 1031 exchange can generate enormous pressure for a taxpayer. Given that most people believe real estate is not fungible, taxpayers face a daunting task when seeking to locate replacement property. Actually closing on replacement property while keeping one eye on the ticking clock can prove troublesome.

Every taxpayer choosing to undertake a 1031 exchange presumably expects to obtain new property while simultaneously deferring tax. In the event replacement property is not acquired, taxpayers can find themselves with unanticipated cash and a current tax bill. In this unforeseen, but all too frequent scenario, an Exchange Transaction may provide relief.

Although a taxpayer would not obtain the complete deferral benefits provided by a 1031 exchange, an Exchange Transaction would allow the Seller to report gain on the sale of his property over time as payments are received. Moreover, given that a taxpayer started the transaction wanting to exchange property, it is likely that he does not want or need cash currently. Thus, an Exchange Transaction may be appropriate.

There may be refinements in this proposed template, and practitioners and taxpayers should tread carefully. The documents are likely to be key to successfully navigating a transaction from an unsuccessful 1031 exchange to a successful Exchange Transaction. However, careful up-front planning may shield taxes that otherwise would become due upon a failed 1031 exchange.

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Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.

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If you are a fully licensed Qualified Intermediary and would like to be evaluated and possibly added to our network of QI state and local providers, please call us today at: 1-877-812-1031

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