Is it really that time of the year again? I can remember writing this same post toward the end of 2007 in preparation for year-end 1031 exchange planning back then. The time flys faster and faster each year, and it is that time again to talk about 1031 exchange planning at year-end.
Year-End Tax Planning for 1031 Exchanges
I am not going to comment on the Presidential election results right now since the actual results will not affect our discuss about year-end tax planning, unless you have a 1031 tax deferred exchange that fails or will otherwise not qualify for tax-deferred like-kind exchange treatment. The depreciation recapture, capital gain, and other income tax rates for 2009 might be substantially higher now that President-Elect Obama is preparing to take over.
Your 1031 Exchange Fails to Qualify
O.K., enough about the election results for now. We need to discuss 1031 exchange year-end tax planning for those 1031 exchanges that fail to qualify for 1031 tax deferred exchange treatment.
The real question becomes what do you do when you begin your 1031 tax deferred exchange transaction in the 2008 tax year and your 1031 tax deferred exchange fails to qualify for 1031 tax deferred exchange treatment either because you did not identify any replacement property during the 45 day identification period or you did not acquire the replacement property identified during the 180 day exchange period? The answer may surprise you!
1031 Exchanges Work Like Installment Sales
The 1031 tax deferred exchange that you started in the 2008 income tax year fails. Now what happens? When do you report the failed 1031 tax deferred exchange and pay the taxes on the taxable sale?
There is lots of misinformation in circulation today and many tax advisors do not even know that the 1031 exchange works like an installment sale. So, the answer to the question depends on when you (the taxpayer) has the right to access your 1031 exchange proceeds held by your 1031 exchange Qualified Intermediary.
If your 45th calendar day identification period or your 180th calendar day exchange period land in the following year and the 1031 Exchange Agreement includes the correct language from the Deferred Exchange Regulations issued by the IRS to restrict your right to access your 1031 tax deferred exchange proceeds, the depreciation recapture would be recognized and taxable in the current income tax year when you sold your property (2008) and the capital gain would be recognized and taxable in the following year (2009) when you have the right to obtain your 1031 tax deferred exchange proceeds.
Your failed 1031 tax deferred exchange works in conjunction with the installment sale rules pursuant to Section 453 of the Internal Revenue Code. Your capital gain is therefore not taxed until the following income tax year because you do not have the right to receive the 1031 tax deferred exchange net proceeds until the following income tax year provided the 1031 tax deferred exchange documents are drafted correctly.
Save the Failed 1031 Exchange with a Deferred Sales Trust
You might also qualify for the Deferred Sales TrustTM if your 1031 tax deferred exchange documentation was properly structured prior to the sale of your relinquished property closing.