When an Exchange Straddles Two Tax Years
As we begin another new year, many Exchangors will find themselves with an exchange that straddles two tax years. That situation usually leads to one of two questions:
- My exchange was a success, but what year do I use to report the transaction?
- My exchange failed. I got my money back, but when do I report the gain?
The first question is easy. The exchange is reported on IRS form 8824, for the tax year in which the relinquished property was transferred. So, for an exchange that began in 2021 and concludes in 2022, the transaction is reported on the taxpayer’s 2021 tax return. If there are unused exchange funds, or “boot”, the receipt of such funds can be reported on the 2022 tax return, using IRS form 6252.
As for the second question, the IRS Regulations provide an option that gives taxpayers some welcome flexibility. A failed exchange which straddles two tax years may be treated as an installment sale under IRC §453. Reg. §1.1031(k)-1(j)(2). In most years taxpayers would jump at the opportunity to push any gain into the next tax year. However, given the current uncertainty over capital gains rates, taxpayers should consult with their tax advisors about any potential benefits from opting out of installment treatment and recognizing the gain in 2021. Of course, each 1031 exchange transaction is different, and taxpayers should always discuss the particulars of their exchange with their tax advisor.
An exchange will fail if no replacement properties are identified within the 45-day ID period. In that instance, installment treatment is available if the identification period had extended over two tax years. The exchange will also fail if the Exchangor was unable to acquire any of the identified replacement properties before the end of the exchange period.
To qualify for installment treatment the taxpayer must demonstrate that there was a bona fide Intent to complete the exchange. Installment treatment will be denied if the IRS determines that the exchange was a sham, used solely to obtain installment sale treatment for the gain. To establish bona fide intent the taxpayer must show that there was a reasonable belief, based on facts and circumstances at the beginning of the exchange, that like-kind property would be acquired before the end of the exchange period. Reg. §1.1031(k)-1(j)(2)(iv).
The IRS challenged the taxpayer’s intent in Smalley v. C.I.R., 116 T.C. 450, 2001 WL 667858 (2001). The taxpayer had exchanged the right to cut timber growing on 3 timberland parcels during a 2-year period. The exchange began in 1994 and was completed in 1995. The IRS assessed a deficiency for 1994, on the grounds that the exchange did not involve like kind property and that it was not reasonable to believe that the properties were like kind. The Court held for the taxpayer, finding that the taxpayer clearly showed a bona fide intent through the use of an exchange agreement, a qualified escrow, and by obtaining expert advice on the issue of like kind property.
In another ruling that favored the taxpayer, the IRS granted a limited liability company's request to revoke its election out of the installment sale method after a failed exchange. Apparently the accountant did not recognize that the property sale qualified for installment treatment, resulting in an inadvertent election out of §453. As a consequence, the proceeds were reported in the year the Relinquished Property was transferred. Once made, the election out could only be revoked with the consent of the IRS. Fortunately, in this case the IRS allowed the taxpayer to undo the mistake and use the installment method. Be aware that a revocation is not allowed if one of its purposes is to avoid federal income tax. PLR200813019.
The ability to control the timing of tax payments is a powerful tool, so remember that all is not lost if your exchange fails. You may benefit from reporting the gain using the installment sale rules. As with any tax reporting issue, you should consult with your accountant or tax advisor to determine the best way to meet your investment objectives.
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