Potential Tax Benefits of A Failed Exchange

In our second example, our taxpayer opens a 1031 exchange and closes on her relinquished property on December 3, 2022. During her 45-day identification period, she is unable to locate suitable replacement properties. On day 46, January 18, 2023, the qualified intermediary releases the exchange proceeds back to the taxpayer. Because the funds were released to the taxpayer in 2023, she can report the 2022 sale under the installment sale method and, therefore, report the proceeds received in 2023.

For reporting purposes, an IRS Form 6252 is filed for the year of the relinquished property closing. Any funds held by the qualified intermediary should not be reflected on Form 6252 until the following year when the funds are actually released to the taxpayer.

CAN I ELECT TO PAY ALL OF THE TAX IN THE YEAR OF CLOSING RATHER THAN OVER TIME?

Yes. It is possible to elect to pay all of the tax in the year of closing, even if some payments will be received in future years. To make this election, you must:

• Report the sale on Schedule D of Form 1040 and/or Form 4797 rather than the Installment Sale Form 6252
• You must make this election by the due date, including extensions, for filing your tax return
• If you file your tax return without making this election, you can still make the election by filing an amended return within six months of the due date.

Once you make the election to be taxed in the year of closing, you will owe tax on all of the gains, even the gain that is attributable to payments you will receive in the future, and you cannot easily change your election so that you are taxed over time using the installment method. Once you elect to treat the transaction as taxable in the year of sale, you can only revoke your election and go back to installment sale treatment with IRS approval.

The regulations do not address how to handle liability relief (when sale proceeds from your relinquished property are used to pay off debt secured by that property) and whether any tax on gain attributable to liability relief is due in the year of the sale or in the following tax year. Revenue Ruling 2003-56 related to a partnership whose exchange straddled two tax years and held that if the exchange straddles two taxable years of the partnership, the amount of the relinquished liability that exceeds the amount of the replacement liability is treated as money or other property received in the first taxable year of the partnership since the excess is attributable to the transfer of the relinquished property. This reasoning should also apply to other taxpayers.

As with any tax reporting issue, you should consult with your accountant or tax advisor to be sure that you report an incomplete or failed exchange in the best way to meet your investment objectives.