Just because you’ve decided to sell a property in a taxable sale doesn’t mean you have to pay your entire tax burden this year.
There are many reasons why property owners, even those whose properties have been used in previous Section 1031 like-kind exchanges, elect not to perform a 1031 exchange and instead pursue a taxable sale. Perhaps they think the capital gains tax rate is likely to go up in the future and want to take advantage of the current rate; maybe they want to use the sale proceeds to invest in non-real property or other investments that won’t qualify under Section 1031; or it could be that they’re moving out of the country for retirement and don’t wish to continue owning U.S. property.
Whatever the reason, when property owners sell, the tax burden can be significant. For some exchangers, being able to defer capital gains taxes even by a matter of months could make a big difference. For example, if you’re working now but plan to retire next year; if you have other realized gains this year that are pushing you into a higher tax bracket, but won’t have that additional income in subsequent years; or if you plan to have sizeable write-offs in the future that you won’t enjoy this year. For many taxpayers, when you sell your property can be of the utmost importance.
If you’re planning to sell a business or investment property without performing a 1031 exchange – or if you’re not sure you can successfully complete your exchange – there are ways to reduce the immediate tax burden on a property sale. Whether 1031 is a part of your plans or not, it can be helpful to know about these other parts of the tax code and when they come in handy.
How tax straddling can ease the stress of a failed exchange
One of the most common ways a 1031 exchange can fail is when the exchanger fails to identify a suitable replacement property within the 45-day window. When that happens, an exchange is no longer possible.
Capital gains taxes on the property sale are assessed for the year in which the exchanger takes receipt of the sales proceeds, which in this case would be Day 46. But what happens when the relinquished property is sold in one year, and Day 46 falls in another year?
This is what is known as tax straddling, and it can be a way to hedge against 1031 failure. By structuring your exchange so that Day 46 falls after the first of the new year, the taxes on the property sale would apply to the following year’s tax return.
With an extra year before those taxes are due, exchangers have time to make additional moves that might affect how much they owe, whether that’s deferring the realization of other gains, investing in Opportunity Zones or other tax-advantaged investments, or setting up additional property exchanges. Knowing ahead of time that the gain from this property sale will be included in their income for the following year gives exchangers time to make informed choices.
Another way an exchange can fail is if properties are identified, but the exchanger isn’t able to acquire any of the identified properties by Day 180. The same principle would apply – if the relinquished property is sold in September and Day 181 isn’t until March, the exchanger would have until the following year’s tax return before having to pay capital gains taxes.
Tax straddling is not possible for every exchange. The exchanger must demonstrate a “bonafide” attempt to complete their exchange, and the ownership structure used will affect how and when taxes are assessed. To learn more, read our blog on the subject.
While tax straddling can allow exchangers to put off tax payments for a time, it can’t change the fact that the exchange has failed. There is no way around the 1031 timeline – once an exchange fails, the sale is taxable. But by understanding another part of the tax code, it’s possible to spread that tax burden out over a period of time.
What is IRC 453a and how does it help with taxation?
With tax straddling, the issue is when the relinquished property sale closes. If it’s before November 16th, then a failed exchange at Day 46 would still be taxable this year. If it’s on or after November 16th, a failed exchange at Day 46 would be taxable the following year. Either way, the entire tax burden applies to one year or the next. But with a Section 453 installment sale, that tax burden could be spread out over several years.
453 of the Internal Revenue Code lays out the rules for this installment method. It’s quite a wordy section, but the most important bit is this: “the income recognized for any taxable year from a disposition is that proportion of the payments received in that year.”
If you receive payment for a property sale in installments, the gain from each payment would be taxable for the year in which that payment was received. It would take longer for you to receive all your sales proceeds, but instead of paying your entire capital gains tax burden all at once, you could spread it out over several years.
A Section 453 installment sale can only be performed with real property valued at more than $150,000, and the seller must report the sale on IRS Form 6252, Installment Sale Income. There are many specific rules for how the sale can be structured – such as the rule that the second payment cannot come more than two years after the first – so it is important to consult with trusted legal and tax advisors before embarking on an installment sale.
While the tax liability can be spread out over as many as 30 years, doing so requires an installment sale agreement with the buyer, who may or may not be open to the arrangement. Some buyers may want to pay over time, while others may object to the idea of paying interest (without which your delayed payments would lose value due to inflation). The seller must pay interest on the deferred tax liability if the outstanding obligation exceeds $5 million.
A common question is whether you can turn a failed exchange into a Section 453 installment sale after the fact. In other words: on Day 46 or Day 181, once your 1031 exchange has failed, can you pivot to an installment sale?
For a forward exchange, the answer is most likely no, because you will already have taken receipt of funds from the failed exchange. However, when planned ahead of time, it’s sometimes possible to combine the two: if you find a buyer for your relinquished property who wants to pay in installments, but you want to execute a 1031 exchange, it may be possible to do both, as the installment sale promissory note can be exchanged for a like-kind property. This requires the agreement of the seller of the replacement property, who may or may not be interested in exchanging for the promissory note.
While incorporating an installment sale as part of a 1031 exchange is possible, it’s more likely for taxpayers to view Section 453 as an alternative to 1031.
Why a 1031 exchange is still the best option for tax deferral
A Section 453 installment sale allows for the deferral of some capital gains taxes while giving the seller the ability to use their sales proceeds to purchase any type of asset, without being limited to real property like with Section 1031. But because payments are deferred, the seller can’t invest that money now, meaning they could lose out on opportunities that may arise while waiting for their deferred payments.
Some taxpayers may consider performing a Section 453 installment sale because they’re already planning to sell in a taxable sale due to some of the reasons we listed in the intro. What they may not know is that a 1031 exchange could still be possible for them, eliminating the need to defer taxes through an installment sale.
Section 1031 allows for state-to-state exchanges, so property owners moving to a new area may not have to choose between selling their assets in a taxable sale or holding onto property in another state. And if you own property as part of a partnership that is dissolving, the drop-and-swap method allows individual exchangers to become tenants-in-common so they can pursue individual 1031 exchanges.
1031 also provides specific advantages for retirement and estate planning, particularly through the use of Delaware Statutory Trusts (DSTs). By taking advantage of the diversification and passive income a DST can provide, retirees can lessen their active management burdens and receive income in retirement, while also holding assets that can be more easily divided among their heirs.
For those hesitant to pursue an exchange because they worry about being able to secure a replacement property in the time permitted, a reverse exchange allows them to buy their replacement property first and sell the relinquished property after. A reverse exchange can be a smart strategy in a competitive market where finding a buyer is easier than finding a replacement property.
For all these reasons, we still think a 1031 exchange can be the best move for most property owners. While a Section 453 installment sale is an option, a 1031 exchange allows for greater tax deferral benefits and lets you reinvest your full sales proceeds into a new investment right now.
Whether you’re considering a standard forward exchange, a reverse exchange, a DST, or an exchange incorporating an installment sale, you need to work with a Qualified Intermediary, and you need one that understands the nuances of these complex exchanges. JTC has an experienced team with specific expertise in less-common exchange types, and we can work with you to execute the type of exchange that is best for you.
Learn more about JTC’s Qualified Intermediary services here.
