There are a lot of moving parts and pieces in even the simplest 1031 exchange, and each aspect of the exchange must adhere to stringent Internal Revenue Service requirements and guidelines, without exception.
Things can and do go wrong. Important deadlines can be missed, such as failing to identify and close on a replacement property in time. If your 1031 exchange has failed, there are some options you need to consider since you may be facing significant capital gains and depreciation recapture tax liabilities.
What is an Installment Sale?
In a standard forward or delayed 1031 exchange, an investor sells one commercial property and rolls the sale proceeds over into a like-kind replacement. Once the exchange is completed, the investor is able to fully defer any taxes realized from capital gains generated from the sale of the relinquished property. Some investors use the exchange process to trade up for properties of greater value, or to diversify their real property holdings by asset class, type and geographical location.
An installment sale works a bit differently. Rather than purchasing the property outright, the buyer of the relinquished asset agrees to pay the seller the full purchase price (usually with additional interest added) over time. Think of an installment sale as a seller-carried loan. Installment payments can be spread out over multiple years depending on how the sale agreement is structured.
This approach can benefit buyers with limited access to cash because they can still purchase properties that would be out of their financial reach if they had to fully fund the purchase up front. Sellers, meanwhile, can spread the income received from installment payments out over multiple years, which reduces the amount of their taxable income in any single year. It’s important to note that any income received after the exchange is completed is taxable, unless it’s structured as part of the exchange and the funds are handled by the exchange facilitator.
Failed 1031 Exchange Installment Sale: What Happens if the Exchange Fails?
If for some reason your 1031 exchange installment sale fails, you have a few options that may allow you to defer some of your capital gains tax liability, or at least spread it out into the following tax year.
You may be able to complete a partial 1031 exchange, where you defer some of the gain realized from your relinquished property. Any funds not included in the exchange are considered boot and are subject to depreciation recapture and capital gains taxes.
You also may be able to structure the entire deal as an installment sale under Internal Revenue Code Section 453. Normally, taxes from the sale of an investment property are due in the same year the asset was divested. Under Section 453, you can defer your tax liabilities into the following tax year.
Setting up the disposition of the relinquished asset as a structured sale, meanwhile, may allow you to defer paying capital gains taxes over the length of the sale contract. Depreciation recapture taxes will be due in the year the asset was sold, but you can spread out your capital gains tax liability into multiple tax years. This strategy may allow you to create offsetting financial positions if you expect to have some capital losses.
Lastly, you can always choose to meet any tax obligations generated from the failed exchange and simply move on.
Putting it all Together
We’ve covered installment sales and failed exchanges in general terms – the options for your particular exchange situation may be different from what’s been briefly discussed here. Additionally, your options may largely depend on the language contained within your exchange agreement.
Consulting with an attorney, tax professional, qualified intermediary and others who are well-versed in 1031 exchange laws may help you come up with an appropriate solution to your failed 1031 exchange.
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. It should also not be construed as advice meeting the particular investment needs of any investor.
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.
