How to Find Success in a Failed 1031 Exchange

Section 1031 exchanges (“1031 exchanges” or “exchanges”) periodically transpire over the course of two tax years. Let’s say a sale of real property occurs on November 20 of year 1, and on March 1 of year 2 the qualifying purchase/exchange is executed. In the case of a successful 1031 exchange, any non-like-kind property (e.g., net liability relief or cash), also known as “boot,” is taken into taxable income in the year in which the sale occurred (i.e., year 1), and the remainder is treated as a deferral of gain. However, in the case of a failed 1031 exchange, crucial questions arise. In which year does the taxpayer realize the gain? Is it possible to get a deferral of the gain to year 2 after failing to identify or acquire replacement property? Department of Treasury regulations address the tax consequences of an incomplete exchange straddling two tax years.

If there is a bona fide intent to execute a 1031 exchange, but the exchange nevertheless falls through or results in excess cash not used in acquiring replacement property, the exchange can be treated for tax purposes under the installment sale rules. The regulations provide that exchange proceeds held by a Qualified Intermediary (“QI”) and returned to the taxpayer can be reported as installment sale proceeds whereby the taxpayer will recognize the cash boot, or gain, in year 2.

Bona fide intent is met only when it is reasonable to believe, based on all of the facts and circumstances as of the beginning of the exchange period, that like-kind replacement property will be acquired before the end of the exchange period. One of the general requirements is that a taxpayer has no rights to receive, pledge, borrow or otherwise obtain the benefits of the cash while it is in the hands of a QI. As a result of these restrictions, the taxpayer is treated as not having constructively received the cash during the exchange period.

Assuming there is bona fide intent, the installment sale treatment applies to cash returned by the QI where (1) excess cash was not used in a completed 1031 exchange; (2) cash is returned due to a failure to identify replacement property within 45 days; or (3) cash is returned due to a failure to acquire replacement property within 180 days. The regulations do not address whether the installment sale method applies to boot received as a result of liability relief. However, the IRS addressed this issue in a separate revenue ruling and concluded that if the amount of the relinquished liability exceeds the amount of the replacement liability, it is treated as money or other property received in year 1, since the excess is attributable to the transfer of the relinquished property. Therefore, gain to the extent of this liability boot would be recognized in year 1, even with the installment sale treatment.

It is always important to coordinate and plan 1031 exchanges with a tax advisor in order to both achieve tax objectives as well as avoid any unintended tax consequences. As noted above, there are certain risks involved with attempting to complete a 1031 exchange, such as the inability to locate replacement property. Nevertheless, provisions such as this installment sale provision help to mitigate negative tax impacts when they may arise. Another mechanism that can be used to help defer taxation on gains from failed 1031 exchanges is the use of a Qualified Opportunity Fund (“QOF”).