An exchanger opening a 1031 exchange in 2006 and which remains open into 2007 may still receive a limited tax deferral despite the partial or complete failure of the exchange. The tax on the gain from the 2006 sale will not be considered received by the exchanger until 2007 (rather than 2006) with the resulting tax payable in 2007 (rather than 2006).

The exchanger could receive the cash from the Qualified Intermediary as the result of the failure to identify replacement property within the 45-day identification period. The cash could also be received at the end of the 180-day exchange period because of the inability or failure to use all exchange funds to acquire replacement property.

The interaction of IRC sections 453 and 1031 provides this benefit to the exchanger. Section 453 concerns the tax treatment of installment sales. It provides that a seller receiving a note as part of the purchase price is not taxed upon the note when it is received. Rather, the seller owes tax as the principal payments are received. If, for example, the note is payable over three years, the taxpayer owes tax on one-third of the payments on the note at the end of each of the three years. This installment sale treatment is applicable to an exchanger who receives funds from a partial or failed exchange allowing deferral of tax for one year.

The installment sale treatment is available to the exchanger only if the exchanger "has a bona fide intent to enter into a deferred exchange at the beginning of the exchange period. A taxpayer will be treated as having a bona fide intent only if it is reasonable to believe, based on all the facts and circumstances as of the beginning of the exchange period that like-kind replacement property will be acquired before the end of the exchange period." Reg 1.1031(j) (2) (iv) IRS regulations provide the following example. In November, 2003, a corporation decides to expand by exchanging unsuitable property for property suitable for the expansion. On November 28, 2003 the unsuitable property is sold and the proceeds placed with a Qualified Intermediary. In early January 2004 the corporation's directors meet and decide that it is not feasible to proceed with the expansion due to a downturn in business reflected in the corporation's financial statements for the last quarter 2003.

The QI delivers the cash proceeds from the 2003 sale to the corporation on January 12, 2004 at the end of the identification period. All corporate actions are properly recorded in the minutes of the directors' meetings. The corporation had a bona fide intent to exchange and the gain on the property sold in 2003 may be recognized in 2004 [meaning tax on the gain is payable in 2005].

Another example from the IRS regulations involves an exchanger, who opens an exchange with $100,000 in September, 2003. On March 11, 2004 the exchanger acquires replacement property having a fair market value of $80,000. The $20,000 balance is released to the exchanger by the Qualified Intermediary at the same time. The exchanger may report the $20,000 gain in 2004 and pay the tax due in 2005. Again, the exchanger had a bona fide intent to complete the exchange. It is important to note that IRS regulations do not specifically address the issue of debt relief in this context. Debt relief is taxable boot.

Source: Property Line 1/9/07