With its share of tricks and treats, we’re not sure which is more daunting – the Internal Revenue Code or Halloween? During this time of year, a treat worth mentioning is that the Tax Code has provided taxpayers who are attempting a fourth quarter 1031 Exchange with a potion that can alleviate the sting of not completing an exchange if the taxpayer is not able to locate new property. This treat is known as “tax-straddling”.
If a 1031 Exchange is successfully completed, the taxpayer defers the taxes that would normally be due on the sale of their real estate by simply purchasing new real estate within 180 days and following the rules listed in Section 1031 of the Tax Code. However, due to challenges such as time limitations and/or market conditions, some taxpayers are unable to complete a successful exchange. Fortunately for those who are unsuccessful during an end of year exchange, tax-straddling allows for a different form of deferral.
Let’s assume a taxpayer attempts an exchange (with bona fide intent) in the later part of 2018, but the exchange is not successful. The taxpayer will then have to report the gain from the sale on their 2018 tax return, right? Not necessarily. If the attempted exchange carries into 2019, the taxpayer may not have either actual or constructive receipt of the sales proceeds until 2019 (Treasury Regulation 1.1031(k)-1(g)(6)). This situation would create an Installment Sale under IRC Section 453.
In this scenario, the IRS has provided the taxpayer with two options:
- The taxpayer can elect to report the taxable gain on the tax return for the year in which the property was sold (2018). Please refer to Publication 537 for election rules;
- The taxpayer can report the taxable gain on the tax return for the year in which the taxpayer came into possession of the sale proceeds (2019). By choosing option B, the taxpayer is granted with a de facto one-year tax deferral on the gains from the sale of the property. (See Section 453 of the Tax Code for details).
The IRS does not penalize investors for attempting to complete a 1031 Exchange. Tax straddling just provides an added incentive to taxpayers selling investment property at the end of the year. Why not attempt to complete a 1031 Exchange when a one-year deferral is available as the back-up plan?
Taxpayers should consult with their tax advisors since tax straddling does not apply to all sales, and any gain attributed to debt relief will still have to be recognized in the year of sale. Please call us at IPX1031 to discuss tax straddling and other valuable tax-deferral solutions. Be sure to consult with your tax advisor to determine if you can take advantage of these valuable tax-deferral methods.
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