A 1031 exchange is a tax-deferred transaction that allows investors to reinvest proceeds from a real estate sale into a like-kind property. If you’re unable to comply with any of the rules the service mandates, you could end up with a failed exchange and a large tax bill. Is there anything you can do if such an event happens? Can you still recover and delay capital gains taxes? The answers depend on the specifics of the failed exchange. Below, Realized 1031 has shared an article outlining potential causes of failure and what to consider if an exchange does not go as planned.
Reasons for a Failed 1031 Exchange
The IRS has many rules for the like-kind exchange, primarily to prevent abuse and preserve the integrity of the transaction. Failing to follow any of these requirements may result in the exchange failing. Here are some example cases.
Missed Deadlines
1031 exchanges must be completed within 180 days after the sale of the relinquished property. Within the 180 days is a 45-day deadline for identifying the replacement property. If you miss these deadlines, no matter the reason, it can result in the recognition of capital gains.
Ineligible Replacement Property
The IRS requires both relinquished and replacement properties to be like-kind, which generally requires that the properties be held for business or investment use. The IRS is flexible on the property type but strict about qualified use.
One common cause of disqualification is the replacement property immediately being converted to a personal use or primary residence. The IRS will recognize this act as a failure to meet the “held for business or investment use” requirement. You must follow timelines set by rules like Revenue Procedure 2008-16 to avoid unplanned tax liability.
Improper Handling of Funds
You cannot have direct control of the sales proceeds from the relinquished property. As such, working with a qualified intermediary is necessary to prevent constructive receipt. Not working with a qualified intermediary will result in tax liability.
Faulty Property Identification
The identification process has its own set of rules. For example, naming more than three properties without meeting value thresholds (set by the 200% rule) can result in a failed exchange. Not formally submitting identification in writing can also trigger disqualification.
Title or Escrow Problems
Delays or mistakes in closing, title transfers, or documentation may cause the deal to fall outside the 180-day window. In reverse exchanges, holding the title of both relinquished and replacement property is also not allowed.
Like-Kind Exchange Failure: What Happens if the Transaction Falls Through
If you fail to follow the rules outlined above, you may face tax consequences. In most cases, the IRS will require you to report and pay capital gains taxes, which can be as high as 20% at the federal level. If the property has depreciated over time, depreciation recapture taxes may also apply, often at a higher rate than standard capital gains, since the former is treated as ordinary income.
The sale will also be reclassified as a standard property sale. You will need to report the transaction on IRS Form 4797 or Schedule D.
If this failed transaction is the first exchange in a cycle that you planned to be longer, the tax consequences won’t be as bad. However, a failed like-kind swap that’s been part of previous exchanges can result in a substantial tax bill, as multiple years of deferred gains may become taxable in the current year.
Can You Still Recover From a Failed 1031 Exchange?
In the case of a failed 1031 exchange, “recovery” does not mean reinstating the tax-deferred status. You cannot gain it back, but the situation doesn’t have to be hopeless. Instead, the next best thing to do is to mitigate the financial damage.
There are other strategies you can leverage to offset the tax hit or reinvest the gains. Working with a tax advisor can help you learn and try approaches like Opportunity Zones or installment sales, which may support partial recovery. It’s important to act quickly, as some of these strategies are time-sensitive.
1031 Exchange Steps After a Failed Transaction
Here’s what you can consider after a failed exchange to help manage the financial impact:d.
- Consult a Tax Advisor: Before anything else, make sure to talk to a qualified tax professional. They can help assess your potential tax liability, ensure proper reporting, and identify options that may still allow for some level of tax deferral or planning flexibility.
- Consider a Partial Exchange: If you successfully reinvested a portion of the sale proceeds, that part may still qualify for deferral. The unspent portion will be taxable as cash boot, but the tax benefits associated with the reinvested portion may still apply.
- Research Other Strategies: An installment sale, for example, allows you to lower tax liability by spreading payments over a few years. Meanwhile, investing in a Qualified Opportunity Fund (QOF) could offer deferral or adjustment of capital gains, depending on eligibility and timing.
Seeing Another Perspective
A failed 1031 exchange, while disruptive, doesn’t always have to be a major setback. A strategic investor will find ways to turn this development into an advantage. For example, you may recognize that market conditions have changed during the 180-day timeline. New opportunities may have emerged that make tax payments a fair trade-off. Evaluating these options with a professional can help ensure that short-term tax implications are considered alongside long-term objectives.
Wrapping Up: 1031 Exchange Considerations After a Failed Transaction
Given the many rules surrounding 1031 exchanges, there’s always a possibility of a transaction falling through, and a failed 1031 exchange cannot be redone or recovered. These developments do not have to be the end of the road, as there are other approaches you can try. Some may even consider paying off the tax liability because the freed capital is presenting new opportunities. Whatever the case, make sure to consult with tax professionals to learn the next best step.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/
https://www.irs.gov/pub/irs-drop/rp-08-16.pdf
https://www.mass.gov/info-details/re27rc07-1031-tax-deferred-exchanges
