As year end approaches and many consider their tax planning strategies, some investors may actually benefit from a failed Section 1031 Exchange. Briefly, an IRC Section 1031 Exchange is a vehicle within the Internal Revenue Service Code that allows a property owner to sell appreciated property (most often real estate) and defer the tax on the gain, by investing in another property within a very specific set of rules and based on stringent time frames. If the transaction fails to comply with the time frame, the Exchange will fail and the gain is recognized immediately . . . unless you FAIL with grace. You can “slip up” on your Exchange and still qualify for tax deferral using a method referred to as “Straddling A Tax Year”, using the Installment Sale Reporting.
Straddling causes gain recognition in the year that the Exchange fails, instead of the year in which the property was sold. For example, if a property is relinquished (sold) in 2012 and the Exchange ‘fails’ to close in 2013, the tax may be deferred until the 2013 tax return is filed in 2014. How, you might ask? The Straddling method relies upon two different time periods. The first time period is the Identification Period. During this 45-day time frame, following sale of the first property, the 1031 client must identify the Replacement Property, or the property that is intended to be acquired. The second time period of 180 days is referred to as the Exchange Period. Prior to the expiration of the Exchange Period the 1031 client must acquire the Replacement Property which was identified during the first 45 day time frame.
If the Identification Period or the Exchange Period “straddles” into the following tax year, this straddling may be beneficial from a tax standpoint. Accordingly, there are two windows of opportunity in which this straddling can be utilized. The first being July 5th through November 16th, and the second being November 17th through December 31st. By selling a property between July 5th and November 16th a tax straddle will be created only if you have identified the replacement property with the intent to purchase during the Exchange Period. This is a crucial step to ensure that the exchange does not fail in the current calendar year. The November 17th through December 31st window does not require the 1031 client to identify the Replacement Property by year end. The reason is because the 45-calendar day identification period overlaps into the following calendar year.
Of course, as with any tax planning, there are certain caveats: you must pass the “bona fide” intent requirements of the Code; partnerships may require the gain be attributable in the year the property was sold (due to Revenue Procedure 2003- 56) and quarterly tax payers should closely coordinate this approach with their CPA as their Estimated Payment Rules may dilute or completely eliminate the tax straddling benefit. A comparison of the due date of ones tax return filing date should be made as it relates to the 180th day, as the Exchange Period may expire prior to the 180th day. This will allow for the “failing” taxpayer to receive their proceeds sooner rather than later. For instance, April 15th filing taxpayers should either finish their exchange by midnight of April 15th or extend their filing date to allow for the full 180 day period when they have relinquished property between Oct. 17th and December 31st of the year (excepting in leap year). If you are failing the Exchange, you would forgo the extension to obtain the funds prior to the180th day.
By preparing in advance for your property exchange and being armed with the correct tools, Tax Straddling can work for you.
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