Completing a 1031 exchange can be an excellent method of making changes in your real estate portfolio while deferring capital gains and other tax obligations. However, the effort requires advanced planning and discipline to succeed. Investors should begin considering potential replacement assets before selling the property targeted for relinquishing in most cases, particularly when competition for real estate is challenging, as it is today.
Investors also should consider identifying their qualified intermediary before beginning the process because that individual or company is crucial to the successful execution of the exchange. In addition, since the QI must fulfill key tasks—including acquiring replacement property or properties, holding proceeds in separate accounts, and managing the required documentation—it's essential to have the role filled before starting the transaction.
What Is an Installment Sale as it Relates to a 1031 Exchange?
An installment sale is a disposition of property in which the seller will receive one or more payments in a tax year after the one in which the disposition occurred. As the IRS notes in Publication 537, "The buyer's obligation to make future payments to you can be in the form of a deed of trust, note, land contract, mortgage, or other evidence of the buyer's debt to you."
How Does Seller Financing Impact the Timing of the Exchange?
Suppose that a seller is financing all or part of the sale and intends to transact a 1031 exchange using the property as the relinquished asset in the exchange. According to opinions from the IRS, the deal can be structured as a mortgage from the buyer, which does not adversely affect the seller. However, the exchange calendar begins when the sale takes place, not when the payment is due. This same structure would apply if the buyer paid some cash and the seller carried a note for the balance, perhaps while waiting for the buyer to complete financing.
What Is an Installment Tax Straddle?
A tax “straddle” happens when your 1031 exchange starts toward the end of one tax year and isn’t completed during the same tax year. The 1031 exchange rules allow taxpayers 180 days from the sale of the relinquished property OR until the date of the following tax return filing deadline, whichever is sooner, to complete the transaction. So, in practice, if you begin your exchange toward the end of a year and you file in April, you may need to request an extension to retain the benefit of the entire 180 days.
The taxpayer can also use a straddle to defer payment of taxes due in situations where they must pay some capital gains taxes due to either a failed 1031 exchange or the receipt of a boot amount. If the taxpayer receives the proceeds in the year after they sold the property, they may report the taxable gain as occurring in that year. It's always best to consult your tax advisor on these topics because there are notable exceptions, including the payoff of a mortgage on the relinquished property.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.