Exchanges Straddling Two Tax Years
Often an exchange period will continue from the end of one year to the beginning of the next. For instance, a taxpayer who sells relinquished property on December 1 will expect expiration of the 45 day identification to occur on January 14 of the next tax year. Similarly, a taxpayer who closes on the sale of relinquished property on September 1 and duly identified possible replacement property within the identification period will expect the 180 day exchange period to expire on February 27 of the next calendar year.
(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s who receive all, or a portion, of their exchange balances in the year following the sale of their relinquished property will receive installment sale treatment for the balance returned. Effectively, this means that they will not have to report the gain on their sale until the time their tax return for the year of the distribution is due.
There is, of course, a catch. A taxpayer should not sell a property with these timelines merely to put off the payment of the gains that are otherwise due. According to the exchange regulations, the taxpayer must have a bona fide intent to do an exchange, even if it is ultimately unsuccessful in whole or in part.
The regulations state:
“The provisions of paragraphs (j)(2)(i) and (ii) of this section do not apply unless the taxpayer has a bona fide intent to enter into a deferred exchange at the beginning of the exchange period. A taxpayer will be treated as having a bona fide intent only if it is reasonable to believe, based on all the facts and circumstances as of the beginning of the exchange period, that like-kind replacement property will be acquired before the end of the exchange period.”
(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s who have the requisite bona fide intent and receive the payout from the exchange account in the second tax year will automatically receive installment sale treatment with the gain to be reported in the year of the distribution from the account. In the event the taxpayer has losses in the year of the property sale, the taxpayer can elect to recognize the gain in that year rather than the subsequent year.
Fallback Strategy for Failed Exchange or Exchange with Unused Proceeds
A portion of exchanges inevitably result in the inability of the taxpayer to identify possible replacement property by the required 45th day from the sale. In other instances, the taxpayer duly identifies one or more possible replacement properties but elects not to acquire the property by the end of the 180 day exchange period. Also, at times a taxpayer will properly identify and acquire replacement property, but does not use up the full available balance of exchange funds. In each of these instances, converting the exchange transaction into an installment sale can provide favorable tax deferral on the amounts in question. There are companies in the marketplace that will assume the qualified intermediary’s obligation to return funds to the taxpayer and, in turn, will enter into an installment agreement with the taxpayer providing for receipt of the funds over time. Some of the features and benefits of such an arrangement include:
- Tax deferral option even when intended exchange does not take place (or for sums leftover)
- The installment payments to the taxpayer are secured
- The taxpayer can design the payment stream
- The taxpayer can receive the certainty of fixed income
- Earn interest of the funds on a pre-tax basis, rather than a lesser amount on an after tax basis
- Defer income to a time of lower income in retirement years
- Ability to borrow up to 85% of the amount involved
Installment sale treatment comes into play when an exchange involves the sale of relinquished property in one tax year and the receipt of replacement property in the following year. Also, for failed exchanges or for exchanges in which some proceeds are left unused, converting the exchange into an installment sale can be a good option in lieu of deferral under Section 1031 of the Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code .