What to Expect from a Failed 1031 Exchange That Spans Two Tax Years

A failed 1031 exchange that spans two tax years can be a complex and frustrating situation. You'll need to consider the tax implications of a failed exchange, which can result in a taxable event.

The IRS considers a 1031 exchange failed if the replacement property is not identified within 45 days or if the replacement property is not acquired within 180 days. This timeline is crucial to avoid a taxable event.

As a result of a failed exchange, you'll be required to report the gain on your tax return for the year the exchange failed. For example, if the exchange failed in December of one year and you sold the relinquished property in January of the following year, you'll need to report the gain on your tax return for the following year.

The IRS will consider the gain from the failed exchange as ordinary income, which can increase your tax liability.

A failed 1031 exchange can have significant consequences, including a taxable event. This can occur when you're unable to acquire a replacement property within the 180-day deadline.

The amount of taxable gain can be substantial, as seen in Example 1, where a $50,000 "boot" resulted from a failed 1031 exchange. This amount can be attributed to depreciation recapture or capital gains.

You may choose to recognize the taxable event on your original tax return, or you could opt for installment sale treatment, as discussed in the context of a properly structured 1031 exchange.

A partial exchange in a 1031 scenario can be a bit of a minefield, but let's break it down. You sold your relinquished property for $500,000 as part of a 1031 exchange, with a 45-day identification deadline of January 14, 2024, and a 180-day acquisition deadline of May 28, 2024.

You properly identified one target replacement property before the deadline, but ultimately acquired it on January 30, 2024, for $450,000, resulting in a taxable event of $50,000. This taxable event could be due to depreciation recapture or capital gains.

This $50,000 taxable event can be recognized on your 2023 tax return or you can elect installment sale treatment.

A failed 1031 exchange can still have some benefits, particularly when it comes to tax deferral. Even if the exchange fails, you can defer gains on the receipt of cash that's not received until the subsequent year.

Section 453 of the code, also known as the installment tax rules, interplays nicely with section 1031 to allow for this deferral. This means you can still get a 1 year tax deferral, even if the exchange doesn't work out.

If you're on the fence about doing a 1031 exchange at the end of the year, setting one up can keep the option open for at least a year.

Tax straddling can be a useful strategy for those who experience a failed 1031 exchange, allowing for a mini-deferral of one additional year before capital gains taxes on the property sale are due.

If your relinquished property is sold and the exchange fails in the same calendar year, your capital gain will be recognized in the year of sale. But if the relinquished property is sold in one year and the exchange fails in another, you can treat the exchange like an installment sale.

You can position the date the exchange fails so that it falls after the first of the new year, essentially receiving a one-year interest-free loan from the government to lessen some of the negative effects of a failed exchange.

There are two windows of opportunity to sell your relinquished property and take advantage of tax straddling: November 17th through December 31st and July 5 through November 16.

If the sale of your relinquished property closes during the first window and you fail to properly identify replacement properties by Day 45, your capital gains will be realized in the new tax year and won't have to be included on your tax return until the following year.

The choice of when to execute your 1031 exchange will come down to your unique situation, and it's essential to work with a Qualified Intermediary that has the knowledge and experience to navigate your individual exchange scenario.

If you sell your relinquished property after October 17, 2023, you must complete your 1031 exchange by April 15, 2024, or file for an extension on your 2023 taxes.

Filing for an extension on your tax return requires submission of Form 4868 and provides a six-month extension on your income taxes, but it doesn't extend the 180-day exchange period.

If you sell your investment property on November 30, 2023, for example, you would have an exchange deadline of April 15, 2024 – only 136 days later.

The balance of your 180 days, in this case, moves the deadline to May 29, 2024, if you file for an extension.

Whether you should recognize the taxable event in 2023 or 2024 depends on your specific situation and is best resolved by consulting your tax and legal advisors.