Exchanges In Process at End of Year - Planning Opportunities

Taxable Income recognized from a 1031 Exchange can be reported under the installment sale rules of IRC §453 if an exchange starts in 2010 and ends in 2011.

Taxpayers who meet the requirements of the regulations are entitled to report any gain recognized on an 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.

If taxpayer has entered into a delayed exchange before the end of 2010 and cashes out or receives cash after December 31, 2010, gain on the exchange can be reported like an installment sale subject to the rules of IRC §453. The Exchange is reported in 2010 but gain attributable to the cash received in 2011 is deferred under the installment sale rules until 2011 and reported on the 2011 return.

Or, if the taxpayer so elects, cash received from the Exchange can be reported in 2010 even though the cash was received in 2011. This gives taxpayers the opportunity of selecting the best year to report the gain attributable to the cash received. Since capital gains tax rates for 2011 will be higher than 2010 unless Congress elects to extend the 2010 rates, this option provides taxpayers with a tax-planning alternative which is flexible enough to accommodate whatever Congress does with the tax rates.

Talk to your tax advisor about your alternatives in this uncertain tax environment. Call us at 888-367-1031 or email us at 1031@1031cpas.com if we can help with any questions. Our Exchange Manual is also available free of charge at www.1031cpas.com. 1031 Corporation is the Intermediary of choice for real estate professionals, CPAs and investors.

Failed 1031 Exchange Gains When QI is Bankrupt or in Receivership

After several 1031 intermediary failures, the IRS has finally granted tax relief for taxpayers who were unable to complete their exchange because their Qualified Intermediary (QI) entered into bankruptcy or receivership.

Revenue Procedure 2010-14 provides guidance on how to report income from the sale of property when a 1031 exchange fails due to a QI bankruptcy. In order to qualify under this procedure, the QI has to be subject to a bankruptcy proceeding under the United States Code or in receivership under federal or state law.

Ordinarily, a sale of property is reported and taxes are paid in the year of sale. If sale proceeds are to be received in installments, the sale can be reported under the “installment sale rules” of Code Section 453. This code section allows the gain to be reported and taxed ratably as contract price payments are received.

In a 1031 Exchange, taxpayers may begin an exchange in one tax year and complete the exchange in a subsequent year. When the exchange "fails", they may not receive their proceeds (known as "boot") until the year subsequent to the relinquished property sale. The tax on the boot received can be deferred to this subsequent year under the installment sale rules (Reg. §1.1031(k)-1(j)(2)).

Revenue Procedure 2010-14 recognizes taxpayers who have entered into an exchange that has failed due to QI bankruptcy or receivership. Taxpayers that have been caught up in a QI bankrutpcy may not posess any of the receiver-disbursed funds until a subsequent year. Taxpayers may receive little or no proceeds from the bankruptcy or receivership until after the proceeding is closed.

Revenue Procedure 2010-14 permits taxpayers to report gain on the sale in a procedure similar to the installment sale rules of IRC §453 and Reg. §1.1031(k)-1(j)(2). Tax on the cash received is deferred until cash is actually received. Taxable gain on the cash received is calculated in a manner similar to the installment sale rules. If the taxpayer received less than the property was sold for, the calculation of the gain is reduced accordingly.

Revenue Procedure 2010-14 is a little more complicated than this explanation. Taxpayers should consult their tax professionals for a complete explanation. With this new recognized procedure for reporting, the IRS has provided clearer guidance to those who have, unfortunately, been caught in a failed 1031 Exchange due to QI bankruptcy or receivership.

Year-end Tax Planning with Section 1031

If you are selling property before the end of the calendar year, you have a potential opportunity to plan for taxes in 2010 by utilizing Internal Revenue Code section 1031 as a tool. Whether a 1031 exchange is ultimately completed or not, there may be an opportunity to choose whether the tax will be paid in 2009 or 2010. This is because, under exchange rules, your right to receive the proceeds from the sale of the property are held by a third party Qualified Intermediary. If you are unable to identify or close on a sale, and subsequently, the exchange fails, your first right to the proceeds doesn't occur until 2010. How is that? It has to do with the time of year we have entered.

Under 1031 exchange rules, a person exchanging property may receive the sale proceeds (a) after the expiration of the 45 day identification period (if the taxpayer did not identify any replacement property); or, (b) the date upon which the taxpayer acquires all replacement property identified by the taxpayer in the exchange, or (c) at the end of the 180 day exchange period. So if you sell a property on December 15th, your 45 day period would not occur until January 29th.

Section 1031 says that if your exchange fails in a different tax year than the year you sold it, the IRS's installment sale rules kick in. So, the taxes that would be due in 2009 could be deferred until 2010. I say COULD be because the installment sale rules also allow you to elect out of them.

If the Obama administration and Congress decide to raise capital gains rates before the Bush tax cut is set to expire at the end of 2010, a taxpayer whose exchange failed could elect out of the installment reporting rules. This also might help if you determine, before filing your tax return, that it would be better to go ahead and recognize the gain in 2009. This stategy, setting up an exchange now, would allow you to plan and recognize the gain in the year of greater tax benefit for you.

Of course, you should have a legitimate intent to complete an exchange and not simply look at this as a tax deferral strategy. However, if you are selling real estate and MIGHT reinvest the proceeds in replacement property, it could certainly make sense to setting up an exchange - just in case. If you are considering this option, you should also consult with your tax accountant or attorney regarding your specific tax situation. For more information on this option, visit our 1031 exchange professionals website or give us a call at 888-367-1031.

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.

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.