A Failed Exchange May Have Tax Benefits

An exchange started near the end of a tax year will often run into the following tax year. The regulations address how to handle incomplete exchanges and cash “boot” received by the taxpayer in the following year.

Generally, the regulations provide that exchange proceeds held by a qualified intermediary can qualify for installment sale treatment if there is a “bona fide intent” to complete the exchange and the exchange falls over two tax years. In these circumstances, you can report cash not reinvested in replacement property as an installment sale in the tax year in which the relinquished property was sold.

So what does this really mean? This means that if you close on a relinquished property in 2021, any cash “boot” received in the following tax year, i.e. 2022, can be reported using the installment sale method allowing you to defer the gain until 2022 when you actually receive the exchange proceeds from First American Exchange Company.

Cash “boot” is any cash not reinvested in replacement property and paid directly to you from the qualified intermediary. This would apply when replacement property is acquired but not all of the exchange proceeds are used or when no replacement property is acquired. 

Let’s look at a couple of examples: In the first example, our taxpayer closes on his relinquished property on November 1, 2021 with sale proceeds of $1,000,000 coming in to the 1031 exchange. He identifies three potential replacement properties and closes on one replacement property on December 15, 2021 using $600,000. If the taxpayer is unable to purchase either of his remaining two identified properties by the 180th day, the remaining $400,000 of exchange funds will be disbursed to the taxpayer on April 30, 2022. Because the $400,000 is cash boot received in 2022, under the installment sale reporting, the taxpayer would report the $400,000 in 2022, rather than the year of sale.

In our second example, our taxpayer opens a 1031 exchange and closes on her relinquished property on December 3, 2021. During her 45-day identification period, she is unable to locate suitable replacement properties. On day 46, January 18, 2022, the qualified intermediary releases the exchange proceeds back to the taxpayer. Because the funds were released to the taxpayer in 2022, she can report the 2021 sale under the installment sale method and therefor report the proceeds received in 2022.

For reporting purposes, an IRS Form 6252 is filed for the year of the relinquished property closing. Any funds held by the qualified intermediary should not be reflected on the Form 6252 until the following year when the funds are actually released to the taxpayer.

CAN I ELECT TO PAY ALL OF THE TAX IN THE YEAR OF CLOSING RATHER THAN OVER TIME?

Yes. It is possible to elect to pay all of the tax in the year of closing, even if some payments will be received in future years. To make this election, you must:

1. report the sale on Schedule D of Form 1040 and/or Form 4797, rather than the Installment Sale Form 6252,
2. you must make this election by the due date, including extensions, for filing your tax return, and
3. if you file your tax return without making this election, you can still make the election by filing an amended return within six months of the due date.

Once you make the election to be taxed in the year of closing, you will owe tax on all of the gain, even the gain that is attributable to payments you will receive in the future, and you cannot easily change your election so that you are taxed over time using the installment method. Once you elect to treat the transaction as taxable in the year of sale, you can only revoke your election and go back to installment sale treatment with IRS approval.

The regulations do not address how to handle liability relief (when sale proceeds from your relinquished property are used to pay off debt secured by that property) and whether any tax on gain attributable to liability relief is due in the year of the sale or in the following tax year. Revenue Ruling 2003-56 related to a partnership whose exchange straddled two tax years and held that if the exchange straddles two taxable years of the partnership, the amount of the relinquished liability that exceeds the amount of the replacement liability is treated as money or other property received in the first taxable year of the partnership, since the excess is attributable to the transfer of the relinquished property. This reasoning should also apply to other taxpayers.

As with any tax reporting issue, you should consult with your accountant or tax advisor to be sure that you report an incomplete or failed exchange in the best way to meet your investment objectives.

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