Failed 1031 Exchanges May Still Provide Tax Benefits

If an investor's 45 day identification period or 180 day exchange period crosses over from one tax year to the next, the investor may be able to defer recognizing any gain resulting from a failure of the exchange to the subsequent year, thereby gaining a year of tax deferral, by reporting the sale as an installment sale under Section 453 of the Internal Revenue Code. This opportunity is only available if the exchange agreement used for the 1031 exchange transaction contains certain required language.

The ability to defer the recognition and reporting of the taxable gain into the following income tax year depends on when the investor has the right to obtain, access or receive the benefit of his or her 1031 exchange funds. The regulations under Code Sec. 1031 contain special rules for coordinating with the Code Sec. 453 installment sale rules. Under Code Sec. 453, gain from a disposition of property for which payments are to be made in later years is generally included in income only as the payments are actually or constructively received. In the context of a deferred exchange where the sales proceeds are held in an escrow or trust account, the question arises whether there has been actual or constructive receipt. Reg. § 1.1031(k)-1(j) says that there is no receipt if the funds are held in a qualified escrow account and the taxpayer had a bona fide intent to enter into a deferred like-kind exchange at the beginning of the exchange. Bona fide intent exists only if it is reasonable to believe at the beginning of the exchange period that like-kind property will be acquired before the end of the exchange period.

The accounts used by All States 1031 Exchange Facilitator are qualified escrow accounts. Pursuant to its exchange agreement, All States 1031 cannot distribute 1031 exchange funds if the disbursement would result in constructive receipt of the funds by the investor or violate any provisions of the 1031 Regulations.

To follow is an example of how this works. If an investor sold property as part of a 1031 exchange transaction on November 30, 2006, the 45 day identification deadline and the 180 day exchange period would both end in 2007, the following income tax year. If the investor failed to identify any replacement property within the 45 day identification period the taxable gain would be recognized in the following income tax year pursuant to the installment sale rules because the investor did not have the right to obtain, access or receive the benefits of the 1031 exchange funds until the 46th day, which in this case falls in 2007.

Likewise, if the investor failed to acquire some or all of the replacement property(ies) that were identified resulting in unused 1031 exchange funds during the 180 day exchange period, the taxable gain would also be recognized in the following income tax year pursuant to the installment sale rules because the investor did not have the right to obtain, access or receive the benefit of the unused 1031 exchange funds until after the 180th day deadline has passed, which also falls in 2007.

The investor may elect out of the installment sale rules thereby recognizing gain in the actual year of sale. Whether or not this election makes sense depends on the investor's income tax situation. The investor should have his or her legal and/or tax advisors carefully evaluate the 1031 exchange agreements and specific facts involved with the failed 1031 exchange transaction to determine when the investor had the right to obtain, access or receive the benefits of the 1031 exchange funds in order to determine whether the gain can be deferred into the following income tax year under the installment sale rules. The investor must then decide, if applicable, which income tax year would be the most beneficial year in which to recognize and report the taxable gain.

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