Revoking an Inadvertent Opt-Out from Installment Method in a Failed 1031 Exchange

An interesting private letter ruling was just released that dealt with an installment sale as it relates to a 1031 exchange. In this case, a taxpayer sold real estate property as part of a planned exchange. However, they were unable to find suitable replacement property within the 180 day exchange period, and the exchange was not completed. The exchange was started in one calendar year and the 180 day period expired in the next year. This failed exchange qualified as an installment sale because the taxpayer did not have receipt of any portion of the sales proceeds in the year that the property was sold.

However, a slight problem occurred. Apparently, the taxpayer’s accountant failed to recognize that the transaction qualified as an installment sale and he reported the gain from the property sale on the tax return for the year the exchange started. Declaring the income on the taxpayer’s tax return amounted to an option to opt out of the installment method. Otherwise, the taxpayer would have been permitted to defer the tax payment on the proceeds from this transaction until the return year that the exchange funds were received.

A section of the Treasury regulations provides that an election to opt out of installment sale treatment is irrevocable, and that “An election may be revoked only with the consent of the Internal Revenue Service.”

When the taxpayer learned of the accountant’s error, it applied to the IRS for consent to revoke its "opt-out" election. The IRS was satisfied that the election to pay the taxes in the first year was inadvertent and the result of the accountant’s oversight - rather than hindsight by the taxpayer or some attempt to avoid taxes. Therefore, the taxpayer was permitted to revoke its election out of the installment method and defer the tax payment on the proceeds until the second filing year.

This reflects both the possibility of deferring capital gains tax over a calendar year on an exchange started late in the year as well as the ability to amend or revise taxes for something inadvertently overlooked by an unknowing accounting professional.

There is also another option for investors of failed exchanges called a Structured Sale Transaction. We'll write about that option next so stay tuned.