As the end of the year approaches, some taxpayers considering an IRC 1031 exchange may hear about the purported benefits of tax straddling. Some believe a tax year straddle can delay their tax liability in the case of a failed exchange; however, a number of factors may limit the efficacy of such a strategy.
A tax year straddle enables a taxpayer to receive IRC Section 453 installment sale treatment on some or all gain recognized on a failed exchange where the exchange period spans two taxable years. Should the exchange fail, the gain on the sale of the relinquished property must be recognized in the second taxable year of the exchange.
Bona Fide Intent
In order to qualify for this treatment, however, the taxpayer must have entered into the exchange with bona fide intent that it reach completion. In most cases, demonstrating bona fide intent is not a challenge. Taxpayers who have engaged a qualified intermediary (QI), relied on advice from appropriate counsel regarding a 1031 exchange, used a qualified escrow account and an escrow agent, or taken similar measures are typically considered to have bona fide intent.
The bona fide intent requirement prevents the use of tax year straddles to defer recognition of a gain in an unsuccessful exchange if the taxpayer had expected to ultimately treat the disposition as a sale.
However, even in the case where the taxpayer achieves installment sale treatment of the gain on an inadvertently failed exchange, several factors may reduce the length of potential deferral and associated potential tax benefits of a tax year straddle.
Depreciation Recapture
In failed exchanges involving depreciation recapture, that gain is taxed as ordinary income, rather than at the lower capital gains rate, to the extent of the depreciation recapture. Though the gain may be eligible for installment sale treatment, the depreciation recapture is recognized in the year of disposition, rather than in the year payment is received.
In many real estate sales, no depreciation will be recaptured because the property has been depreciated on a straight-line basis. However, if the real estate includes IRC Section 1245 real property, which has been depreciated on an accelerated basis, depreciation recapture will occur when that property is sold.
For taxpayers hoping to shift tax liability for the gain into the second year of an exchange using a tax year straddle, the tax costs associated with depreciation recapture in the first taxable year may come as an unpleasant surprise.
Installment Tax Interest
under IRC Section 453A
In some cases, gain recognized on a failed exchange may be subject to an interest charge when the seller is not a dealer and the sales price of the property exceeds $150,000. The IRS takes the position that IRC Section 453A applies to straddle transactions, presumably on the theory that the installment obligation to which Section 453A would apply is the QI or escrow agent’s obligation to return the sales proceeds to the taxpayer in the event that the taxpayer is unable to acquire replacement property within the exchange period.
The interest charge is applied in cases in which both the sales price of the property exceeds $150,000 and the face amount of all such installment obligations held by the taxpayer, which arose during and are outstanding, at the end of the tax year exceeds $5 million. If this happens, the taxpayer will owe interest, calculated pursuant to a formula based upon the maximum amount of tax deferred, the tax underpayment interest rate, and the ratio of the installment obligations in excess of $5 million to the aggregate amount of all such obligations outstanding as of the end of the tax year.
For taxpayers who have made other installment sales in a given taxable year, the additional installment obligation associated with a 1031 tax straddle may place them over the $5 million per year limit, subjecting them to an interest charge they would not otherwise owe.
Though installment sale treatment enables a taxpayer with a failed exchange to defer tax liability until the year the payment is actually received, Section 453A(b)(2) means that taxpayers with larger installment sale deferrals may still have tax liability associated with that deferral in the year of the sale.
Estimated Tax
Additionally, though a tax year straddle may sound appealing, on the assumption that taxes on gain recognized in the second taxable year will not have to be paid until that second year’s taxes are filed, the tax liability will actually come due much sooner in the majority of cases.
If a taxpayer expects to owe taxes on income because the tax liability on that income has not been satisfied through withholding or other means, then it may be required to pay estimated tax with respect to that income. Estimated taxes are paid on a quarterly basis.
Gain recognized on a failed exchange in the second taxable year is often subject to this requirement. As a result, the deferral achieved through IRC Section 453 installment sale treatment will extend, at most, to the second quarter of the tax year following the sale, given the 180-day limitation on the exchange period.
Although tax straddling may initially seem like an effective strategy, in practice, its advantages may be limited. While timing is important to take into consideration when planning a 1031 exchange, the 45-day identification and 180-day exchange periods are far more salient concerns than the placement of the exchange over one or two taxable years.
Kelly Alton is general counsel and Jill Jones is assistant general counse for NES Financial, San Jose, CA.