Failed 1031 Exchange at the End of a Tax Year

What happens to a 1031 exchange if a taxpayer sells his relinquished property and is unable to locate a suitable like-kind replacement property within the IRS deadlines? Well, obviously the exchange has not been completed and the gain and depreciation recapture is taxable. But what happens if an exchange is started before the end of the year and cashes out or receives cash after the end of the year? When does the tax liability on the gain get reported? In the case of a failed or partial tax-deferred, like-kind exchange, a taxpayer may be able to defer some of his tax liability into the following income tax year rather than the income tax year in which the relinquished property closed.

Taxpayers who use the delayed exchange safe harbors and meet the requirements of the regulations are entitled to report any gain recognized on the exchange under the installment sale method of tax accounting (See Reg. §1.1031(k)-1(j)(2)). However, the regulation applies only if the Exchange Property is eligible for like-kind exchange treatment and if the taxpayer had a bona fide intent to enter into a 1031 Exchange.

This means that if a taxpayer enters into a delayed exchange before the end of the year and cashes out or receives cash after the end of the year, the gain on the exchange will be reported like an installment sale subject to the rules of IRC §453. The sale of the Relinquished Property will be reported in the year of sale like an installment sale. Cash received after the end of the year from the Qualified Intermediary is taxed in the following tax year. We should note that the tax due from depreciation recapture is not deferred into the following income tax year and is due in the taxable year in which the taxpayer sold the relinquished property.

Does this seem like a great method of deferring income from one tax year to the next by having a Qualified Intermediary hold the cash temporarily? No - unless there was a bona fide intent to complete a 1031 Exchange and there was an Exchange Agreement with a Qualified Intermediary specifically prohibiting access to the exchange funds until the following tax year under the requirements of Section 1.1031 of the Treasury Department Regulations.

We always recommend investors have a team of trusted professional advisors - an attorney, an accountant, a broker, an escrow officer and a Qualified Intermediary. This team will be of even greater importance in a failed exchange occuring over two tax years. A taxpayer should review his or her exchange agreement and consult with his team of professional advisors to determine when the right to obtain access to, or receive the benefits from, the 1031 exchange funds occured. This will help to determine when the income tax liability is due and whether a portion of the tax can be deferred into the following income tax reporting year.