By Michael S. Brady, Esq., CES®
With the end of the year rapidly approaching, it’s time for all taxpayers to begin the dreaded annual ritual of gathering their tax related documents for the journey to the accountant’s office. This is particularly true for investors involved in a 1031 exchange, but for them it’s not just gathering their papers. Depending on the status of their exchange, the end of the year may present some deadlines to meet and some opportunities to explore.
- Know when your exchange must be completed.
The maximum amount of time a taxpayer has to complete a 1031 exchange is 180 days. This “Exchange Period” runs from the date the taxpayer transfers the Relinquished Property to the buyer. The Replacement Property must then be acquired by the taxpayer by midnight of the 180th day thereafter.
However, the Exchange Period can be shorter than 180 days. IRC Section 1031 actually provides that the Replacement Property must be received by the earliest of the 180th day after the Relinquished Property is transferred, OR the due date, including extensions, for the tax return for the year in which the Relinquished Property was transferred.
For example—a taxpayer who sold Relinquished Property in 2015 would generally need to file their tax return and report their 1031 exchange by April 15, 2016. However, if they closed on the sale of the Relinquished Property between October 18, 2015 and December 31, 2015, the 180th day of their exchange would be April 15, 2016 or later—either on or after their tax filing deadline (Remember-2016 is a Leap Year). Since the 1031 exchange must be reported on the taxpayer’s 2015 tax return, it must be completed before the tax return is filed.
However, all is not lost—if the exchange cannot be completed by April 15, the taxpayer can usually simply file for an automatic extension of six months to file their tax return. They would then have the benefit of the full 180 day exchange period.
It is important to note that corporations and certain non-calendar year taxpayers may have different tax filing due dates that will affect their Exchange Period. Additionally, the Exchange Period includes both weekends and holidays, and the only extensions that have been granted have been where a federally declared disaster occurred during the Exchange Period which impacted the 1031 exchange in one of several specifically designated circumstances.
What happens if Replacement Property is acquired after the Exchange Period? In Knight v. Commission, T.C. Memo. 1998-107, the tax court disallowed a 1031 exchange where the taxpayer did just that. Knight had argued that the IRS should be more “citizen-friendly”, since they claimed they closed on their Replacement Property after the 180th day due to circumstances that were beyond their control. While sympathetic to taxpayer’s plight, the court found that it was bound by the Internal Revenue Code, not principles of equity. The taxpayer was required to recognize their capital gain and pay the resulting taxes, despite having purchased the property.
- Take advantage of tax year straddles.
Since Exchangers have up to 180 days to complete their 1031 exchange, many exchanges will wind up straddling two tax years. As a result, in a failed 1031 exchange the taxpayer may not be entitled to receive their funds until the year following the sale. While this can be a source of aggravation, the restriction can provide a tax benefit.
IRC §453 applies to property sales where at least one payment is received by the taxpayer in the year following the year of the sale. When this “installment method” applies, the payment is not subject to taxation until it is received. What this means is that if a failed 1031 exchange period straddles two tax years, the funds might not be taxed in the year of the sale, but rather in following year, essentially providing up to a year of tax deferral.
Of course, you should keep an eye open for changes in tax rates—when long term capital gain tax rates increased in 2013, the installment treatment was not an attractive option. As a result, many investors wisely opted out and chose to be taxed at the lower 2012 rates.
Additionally, to take advantage of installment sale treatment, the taxpayer must have had a bona fide intention to enter into a 1031 exchange at the time of the sale, such that it was reasonable to believe that replacement property would be acquired before the end of the exchange period.
Finally a taxpayers electing to take advantage of installment treatment should coordinate with their accountant regarding when the tax should be paid.
- Gather documents for your accountant.
Ideally, a taxpayer will have consulted with their accountant before entering into a 1031 exchange so that the transaction is not a complete surprise when the tax return needs to be prepared. Regardless, the accountant will need certain information.
Form 8824 is the form used to report a 1031 exchange to the IRS. At a minimum, the following information and documents are needed to complete this form:
- The closing statement for the sale of the Relinquished Property;
- The closing statement from the purchase of the Replacement Property;
- The account statement from the Qualified Intermediary; and
- The date that the Replacement Property was identified;
The accountant will also need prior year’s tax returns to compute the adjusted basis of the Relinquished Property. They may also need the closing statements from when the Relinquished Property was originally acquired, as well as information regarding capital improvements that have been made to the Relinquished Property.
The end of the year provides a good opportunity to gather and organize information to ensure a smooth tax season.
- Begin 2016 Tax Planning
If you are planning to sell a property in 2016, consider whether a 1031 exchange makes sense and plan accordingly.
If you have partners, discuss whether everyone wants to exchange and whether you plan to invest in a new Replacement property together. If not, you may want to restructure the manner in which title to the Relinquished Property is held, and you may want to do so before the New Year.
Talk to brokers about the potential market for your property. Property values have risen since the recession, and many regions are experiencing a seller’s market. Knowing the value of your property and how quickly it can be sold will be essential to your planning.
Explore financing options for replacement properties. Interest rates have been low, but underwriting requirements have been strict.
Consider whether more passive investments, like Net Lease properties or Delaware Statutory Trusts make sense, and begin investigating the markets and sectors in which you might want to reinvest. If you find an ideal Replacement Property now, a Reverse 1031 Exchange might make sense if you don’t yet have a buyer for your Relinquished Property.
Most importantly, discuss your transaction with a knowledgeable 1031 exchange qualified intermediary, who can alert you potential issues and offer potential solutions. The sooner you begin to plan, the more likely you will have a smooth exchange, and acquire the ideal and profitable Replacement Property.
Michael S. Brady, Esq. is Vice President and Counsel for Riverside 1031 LLC, a national Qualified Intermediary for 1031 Exchanges. He is a Certified Exchange Specialist® and has over 20 years’ experience in real estate and business transactions.