Since the modern-day version of the U.S. Internal Revenue Code (the “IRC”) Section 1031 was amended in 1954, real estate investors have used Section 1031 like-kind exchanges to defer gains on their sale of real property.  Section 1031 exchanges allow sellers to exchange investment real property with other like-kind investment real property without the payment of tax on the gain.[1]  The rationale is similar to IRC Section 351 and other non-recognition provisions: the taxpayer is not cashing out of their investment, but rather is continuing it, albeit in a different form or with a different real property. 

Section 1031 Statutory Requirements

However, in order to defer the gains, the seller must meet the statutory requirements of Section 1031.  First, there must be an exchange of property, and not only a sale.  Second, the property exchanged and the property received must be “like-kind.”  Third, the property exchanged and the property received must both be held for productive use in a trade, business, or investment.  Fourth, there are very stringent identification and timing requirements if the properties exchanged are not done simultaneously.  While this article will not delve into the minutiae of the four requirements, the first three requirements are fairly straight forward.  However, the fourth requirement is generally the most talked about and most difficult to meet.

The IRC requires that the seller to identify the replacement properties within 45 days of the exchange.  As a general rule, the seller can identify either three properties, or as an alternative, any number of properties, so long as, the aggregate fair market value, (at the end of the 45 days), does not exceed 200% of the relinquished property.  After the identification requirement is met, the seller must finish purchasing the identified replacement properties within 135 days after the 45-day identification period or 180 days from the date of the original sale.

Types of Exchanges

There are three types of Section 1031 exchanges.  The most basic, and ironically the least common is the simultaneous exchange.  This is when the seller and the buyer exchange their property at the same time.  For obvious reasons, because the exchange happens simultaneously, the above referenced timing requirement is not necessary.  However, if one party receives boot (in the form of cash or other property) in excess of the exchanged property, the boot is taxable.

The second type, the deferred exchange, utilizes the safe harbors in the Treasury Regulations to assign the seller’s sales proceeds to a qualified intermediary (“QI”) to hold the proceeds until the QI, under the directions of the seller, purchases the exchange property and assigns it to the seller.  Provided the seller complies with the deferred exchange rules, they will not be deemed to be in actual or constructive receipt of the funds held by the QI.

The third type of exchange is the reverse exchange.  This is essentially the opposite of a deferred exchange.  The exchange accommodation titleholder (“EAT”) acquires the replacement property and holds it during the 45-day identification period and during the 180-day transfer period.  Simply, unlike the deferred exchange, where the seller has to buy the replacement property within 180 days, in a reverse exchange the seller has to sell the relinquished property in 180 days.

When an Exchange Fails

Despite the best intentions, lack of inventory, real estate values appreciating, rising borrowing costs, and the tightening of lenders, many sellers are unable to find other willing sellers to participate in their Section 1031 exchanges.  As such, sellers routinely fail to complete their 1031 exchanges and are forced to pay the taxes on the gains.

However, a failing Section 1031 transaction, if done correctly, may be converted into an installment sale under IRC Section 453.  An installment sale occurs when at least one payment of the principal is received after the close of the tax year in which the original sale took place.  Simply, if you sold a property in the current year, but did not receive payment on the property during the current year, the sale would be deemed an installment sale and the taxes due on the gain would not be payable until payments are received in future years (from year 1 to up to year 30 or later).

The Treasury Regulations provide for the conversion of Section 1031 exchanges into Section 453 installment sales.[2]    However, in order to coordinate a Section 1031 exchange with a Section 453 installment sale, the seller is required to have bona fide intent.  As required by the Treasury Regulations, the seller must have the intent to enter into a deferred exchange at the beginning of the exchange period.  The seller is allowed to change their mind anytime but this intent can be achieved when they proceed with a Section 1031 exchange.

To illustrate how an installment sale may be useful in a failing Section 1031 like-kind exchange, if the seller is unable to purchase a replacement property within the 180 days deadline, the seller and a Section 453 QI may enter into an exchange agreement that specifies that the funds held by the Section 1031 QI may be converted into a sale transaction, whereby the seller and Section 453 QI can agree on the terms of the payments (via an installment note), in order for the seller not to pay all of the taxes in year one, but spread out the gain over a future period of time.

Finally, while the seller is forbidden to transfer, sell, assign, pledge, or encumber the installment note, the seller may be able to approach a private lender and borrow money, using the stream of income from the installment note (but not the note itself) as credit.  The transaction may be transacted so that any interest payments paid to the seller from the Section QI can be used to offset the interest payment to the lender for the borrowed funds.

When the above failing Section 1031 transaction is bailed out with a Section 453 transaction, then the gain on sale is deferred into the future years and an optional business loan from a private lender may be available for the seller to use for business or investment purposes.

 

Charles Lee is CEO of Reliant Tax Consulting, Inc. For more information, call (661) 775-5923 or email charles.lee@reliantez.com.



[1] Before January 1, 2018, a wide array of “property” was covered under IRC Section 1031.  However, with the passage of the Tax Cuts and Jobs Act of 2017, all other property for use in a Section 1031 exchange, with the exception of real property, has been repealed.

[2] See Treasury Regulations 1.1031(k)-1