A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows real estate investors to swap one investment property for another while deferring capital gains taxes. Of course, the magic of exchanges for your clients is the ability to use real estate investment the way some people use tax-deferred retirement accounts, such as 401(k)s and traditional IRAs. With the ability to roll proceeds from a property sale into new property investments, clients build wealth and avoid paying capital gains taxes on sales gains until their final sale.
However, sometimes a 1031 exchange transaction will fail, and that’s where a commercial real estate practitioner’s expertise comes in. An estimated 8%–10% of 1031 exchanges fail to complete. The most common reasons include:
- Missing the IRS’s 45-day deadline for identifying a replacement property
- Failing to close on the replacement property within the 180-day limit
- Inability to find suitable like-kind replacement property
- Replacement property value falls short of the relinquished property
When that happens, your client may face a sizable tax bill. But a failed exchange doesn’t have to mean financial disaster. There are strategic ways to minimize the damage, particularly through tax straddling and the installment method.
The Tax Straddling Strategy
When you sell property within 180 days of the end of the year, the like-kind exchange is not required to be completed before the end of the year. This means the exchange will carry over from one tax year to the next and is often referred to as a “tax straddle.”
A qualified intermediary holds the proceeds from the sale during the period before the replacement property is purchased. In the case of a tax straddle, the proceeds from the sale would not be released from the QI to the taxpayer until the subsequent year.
This timing difference can be a game changer for your tax liability.