Common Reasons for Failed 1031 Exchanges
The goal of every Section 1031 exchange is to defer capital gains taxes. To achieve this, taxpayers need to acquire like-kind property in place of their property. At the moment, there is no cap or ceiling on the total tax liability which can be deferred through Section 1031. Politicians have discussed placing such a cap, but right now no such cap exists. If performed correctly, a 1031 exchange can result in the deferral of many millions of dollars in taxes. However, not every 1031 exchange is carried out correctly. A percentage of these exchanges fail for one reason or another. Determining precisely the percentage of exchanges which fail would be difficult, but the phenomenon is not at all uncommon. As we’ve seen, Section 1031 is full of rules, and sometimes taxpayers fail to comply with one or more of these rules.
In this post, we will discuss some of the more common reasons why exchanges fail. Some requirements of 1031 are less likely to be met than others. Below, we’ve identified a few of these requirements. We’ve also discussed the reasons as to why taxpayers fail to meet these requirements. This post reinforces the need to procure effective counsel prior to initiating a 1031 exchange. In addition to contracting with an intermediary, taxpayers should invest in a competent tax attorney to guide them through the process.
Taxpayers Fail to Identify Replacement Property Within 45 Days
We’ve written previously about 1031 identification rules. Taxpayers have a total of 45 days to identify replacement property. This 45 day clock begins on midnight following the close of their relinquished property. The 45 day clock spans 45 calendar days, which means that it includes weekends and holidays. As per the Treasury Regulations, a party to the exchange must witness the identification prior to the end of the 45th day. As strange as it may sound, failure to identify within 45 days is probably the most reason for failure. In a lot of the cases this traces back to simple procrastination. Taxpayers contract with a QI and learn about the 45 day identification requirement. And then the QI fails to remind the taxpayer about the upcoming 45 day deadline. The taxpayer procrastinates and then forgets to make the identification.
Harmless Errors Are Not So Harmless
Though this is a harmless error, this simple mistake causes the whole exchange to collapse. And there is absolutely no wiggle room on this requirement. If the taxpayer doesn’t make the identification, the exchange is over. In other cases, the reason for the failure is related to market realities rather than procrastination. Taxpayers search high and low to find suitable replacement property but fail to find something adequate. They initiate the exchange on the expectation that they will be able to locate something. This doesn’t happen, and then eventually the exchange collapses when the 45 day clock expires. Again, this simple requirement probably causes more exchange failures than any other.
Taxpayers Fail to Comply with the Receipt Requirements
To correctly receive replacement property, taxpayers must comply with the receipt requirement imposed by the Treasury Regulations. Under Section 1031(d)(1)(ii), property received must be substantially the same as the property identified. Complying with this requirement seems simple enough. The taxpayer simply has to purchase and acquire the same property which was formally identified before the 45 day deadline.
In standard, delayed transactions, complying with this requirement is usually quite simple. But complying with this requirement in improvement exchanges is trickier. Section 1031(e)(2) gives special rules for identifying property in improvement exchanges. What’s more, Section 1031(e)(3) provides special receipt requirements for such property.
Substantially the Same
The “substantially the same” requirement includes the fair market value of the property. This means that the received property must have a value approximately the same as the property identified. For improved property, the fair market value at the time of identification is the estimated value at the time of completion. We can see how there can be subjectivity in such situations, and how the IRS may argue that a given valuation may be wrong.
Suppose a taxpayer estimates a property will have a value of $1 million when it’s completed. But then the taxpayer only ends up spending $600,000 on the property. And the completed property includes all of the improvements described in the identification. In this situation, the property received would not be substantially the same as the property identified. The IRS would certainly collapse the transaction upon inspection. This type of problem arises with some frequency in improvement exchanges.
Taxpayers Close Without a Contract with a Facilitator
Another common reason for failure is due to closing property without a facilitator. To qualify for tax deferral, a taxpayer must have a contract with a facilitator in place before closing on the relinquished property. Closing without such a contract will result in the taxpayer having constructive receipt of exchange proceeds.
Constructive Receipt Equals Taxation
Constructive receipt will immediately create a taxable event and render the property ineligible for exchange. In some cases, because they are unaware of this requirement, taxpayers close on their relinquished property without a facilitator. They close simply because they mistakenly believe that they can obtain a facilitator after they sell their property. Like the failure to identify property, this is a very simple mistake, but it happens quite frequently. Again, this is precisely why taxpayers need to consult with an expert when they begin contemplating an exchange. Many a taxpayer desired to defer huge gains only to realize too late that they sold their properly prematurely.
These are just a few of the more common reasons why exchanges fail to result in tax deferral for taxpayers. There are many others as well. Section 1031 exchanges are rather delicate transactions, and so the failure rate is not insignificant.
Our NYC Tax Attorneys Can Help
Again, the best way to avoid pitfalls is to procure competent counsel before an exchange occurs. At Mackay, Caswell & Callahan, P.C., our attorneys have mastered the rules 1031 and are able to help. Navigating the rules of 1031 is something which no taxpayer should do independently. You need someone who can guide you and alert you whenever a tricky area comes up. If you need assistance with an exchange or another tax matter you should consider reaching out to our top New York City tax attorneys.
Image credit: Marco Verch