“Tax Straddles” – Navigating the Complexities of an Exchange Spanning Two Tax Years

By: James T. Walther, Esq., LL.M., General Counsel

When a taxpayer initiates a 1031 exchange near the end of their tax year, it often extends into the following year, creating a situation known as a “tax straddle.” This term refers to the scenario where the sale of the relinquished property and the completion of the exchange span two different tax years. Typically, any gain recognized attributable to a partial or failed exchange spanning two tax years  is reported under the installment method, akin to an installment sale where at least one payment is received after the tax year of the sale. [i]  This means that when cash is disbursed by the qualified intermediary (“QI”) in year two in a failed or partial exchange transaction, the exchanger can delay reporting income related to the cash distribution until they file their tax return for the for the second year. Note, the timing of debt relief recognition will likely apply to the year of the sale and is discussed further below. Tax straddles can offer the benefit of a short-term deferral of gain into the next tax year, serving as a stopgap for failed or partially taxable 1031 exchanges.

Tax Straddles are most beneficial in the following situations:

  1. Fully Failed Exchange: If the taxpayer has a high basis and relatively low debt and starts an exchange in year one that is fully abandoned in year two, most of the debt relieved can be sheltered by basis and the gain from the cash received is not realized until year two.
  2. Relinquished Property with No Debt and All Equity: If the taxpayer completes a partial exchange or fully fails an exchange in year two, an all-cash scenario is ideal because there is no debt relieved upon sale and taxable gain is not realized until they receive cash from a QI.
  3. Partial Exchange with Cash Boot: If the taxpayer completes a partial exchange but replaces all or most of the debt and they receive cash boot in year two, they receive the benefit of reporting the related income in the year two.

Tax Straddles are less beneficial in the following situations:

  1. Individual/Partner’s Share of Debt is in excess of their available basis: Although it is not common, this situation can create tax liability in year one.  This applies to both a fully failed exchange or in a partial exchange where debt is not completely replaced.
  2. Transactions where over $5,000,000 in gain is deferred into year two. Transactions over this threshold include and interest factor, discussed in detail below.

1031 Tax Straddles in 2023-24: This brief outline highlights critical aspects of exchanges initiated in the latter half of 2023. The comprehensive article that follows delves into the tax implications of such exchanges, including timing, recognition of cash boot, debt boot, and other pertinent factors.

  • The IRS allows exchangers to commence an exchange and fail to complete it in the subsequent tax year, provided there is a bona fide intent to acquire replacement property. A bona fide intent to exchange is essential to qualify for the benefits of a tax straddle (Treas. Reg. § 1.1031(k)-1(j)(2)(iv)).
  • If you or your client is currently engaged in a pending exchange, consider extending the filing date for your 2023 tax return until the exchange is fully completed. For more details, we recommend reading our article, Preserving your Exchange Timeline.
  • Individuals initiating a Section 1031 exchange after October 4, 2023, will have their 180-day period coincide with the tax filing due date (April 15, 2024). Since the 2023 tax filing can impact an ongoing exchange, it is advisable to extend the tax filing deadline to fully utilize the 180-day exchange timeline.
  • Partnerships and S-Corps commencing exchanges after September 17, 2023, can also benefit from an extension of their March 15, 2024, filing deadline.
  • Cash boot resulting from a failed or partial exchange is recognized in the year received. If cash boot is disbursed by the QI in 2024, it will be recognized in the 2024 tax year unless the taxpayer chooses to make an election to include it in their 2023 income. See Treas. Reg. § 1.1031(k)-1(j)(2) and PLR 200813019. For information about reporting, see generally, Publication 537; Form 6252 for reporting installments; and Forms 8949 and 4797 for elections.
  • Note that installment treatment is not applicable to debt boot in a tax straddle. The corresponding gain is included as income in the first year of the exchange, 2023. For a more technical discussion on the topic, refer to the main article below.
  • Diminished benefits for large transactions – For large transactions – specifically, installment sales or straddles with over $5 million in gain deferred to a subsequent year – the taxpayer is required to pay interest on the deferred tax amount from one year to the next (IRC §453A(c)).

 

ARTICLE: TAX STRADDLES

Overview of the 1031 Exchange Process: Prior to discussing the nuances of tax straddles, it’s important to understand the basic mechanics of a 1031 exchange. Taxpayers transacting a forward/deferred 1031 exchange (“exchangers”) have a total of 180-days from the date that they sell to reinvest the net proceeds from the sale into replacement real estate. The first 45-days of which are a deadline for submitting a written identification of the replacement property to be acquired. After the sale of relinquished property starts the exchange, the net proceeds (exchange funds) are sent to escrow held by a qualified intermediary (“QI”).  The exchanger’s access to the escrow is restricted until the end of the exchange, except for use in the purchase of “like kind” replacement property. See our Overview Article on the Exchange Process here. Structuring a 1031 exchange using a QI avoids the recognition of gain upon sale and prevents actual or constructive receipt by the taxpayer. See our Article on actual and constructive receipt here.

Upon initiating a 1031 exchange, there are typically three possible outcomes:

  1. Complete Exchange: The exchange funds are fully utilized to purchase replacement real estate, thereby successfully completing the exchange.
  2. Partial Exchange: This occurs when not all exchange value is replaced, including where not all funds are used. The taxpayer can access the remaining funds either at the end of the exchange period on day 181 or earlier if all identified replacement properties are acquired between days 46 and 180.
  3. Failed Exchange: The exchange is deemed unsuccessful if no valid property identification occurs by day 46, or if the exchange is not completed by day 181.

In cases of partial or failed exchanges, the exchanger might incur taxable income, typically in the form of “cash boot,” “debt boot,” or a combination of both. Cash boot refers to any cash or cash equivalent received during the exchange. Debt boot usually arises when the exchanger fails to offset the debt on the relinquished property with equal or greater financing on the replacement property, or when they don’t add sufficient cash to the acquisition to cover any difference in value.

For in-depth discussions about the exchange requirements and debt replacement, see our articles Article “Balancing the Exchange” and “Liabilities Related to Relinquished Property.

“Tax straddles”: A “tax straddle” occurs when a 1031 exchange spans two different tax filing periods, raising questions about the timing and recognition of potential capital gains. For calendar year taxpayers, any exchange initiated after July 5, 2023, may extend into the next tax year, as the 181st day would fall on or after January 1, 2024. Additionally, if an exchange begun after November 17, 2023, fails to identify replacement property within the allotted 45 days, it will end in 2024.

In scenarios where replacement property is identified within the deadline, but the exchange either fails or is partial, the exchanger could have boot (taxable gain) at the end of the exchange period in 2024.

Individual taxpayers who initiate an exchange after October 17, 2023, are advised to request an extension of their tax filing deadline if their exchange remains open into tax season in 2024. This extension maximizes the exchange period, as per IRC Section 1031(a)(3), which states that the tax due date, without an extension, marks the end of the tax year and terminates any ongoing exchange. [ii] Section 1031(a)(3)(B)(1) requires that an application for an extension of time to file a tax return be submitted before the due date. [iii]For partnerships and S-Corps starting exchanges after September 16, 2023, considering an extension is similarly advisable.

 Tax Treatment Considerations of a 1031 “Tax Straddle”

 The bona fide intent requirement, Treas. Reg. § 1.1031(k)-1(j)(2)(iv) provides that for a failed exchange to qualify for installment reporting over the two-year period, the exchanger must have “a bona fide intent to enter into a deferred exchange at the beginning of the exchange period.” Determining bona fide intent is a subjective analysis“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.”[iv] 

 The Tax Court has been generous to taxpayers in applying the regulation’s “reasonable to believe” standard. In Smalley v. CIR, the taxpayer planned and attempted an exchange, with bona fide intent, even though the IRS later challenged the “like-kind” qualifications of the property involved.[v]  Even though the Court and IRS found the exchange invalid, at the time he started the exchange, the taxpayer believed that the property qualified, and he intended to affect a 1031 exchange into replacement property.

Tax Reporting for Cash boot – The installment method is the default rule for accounting for proceeds received as part of an exchange that straddles two tax years.  The taxpayer reports their gain from receipt of the cash proceeds in the year received under the installment sale rules of Section 453.  See Treas. Reg. § 1.1031(k)-1(j)(2) “Coordination with section 453.” Income from cash or cash benefits received at the time of the relinquished property sale is typically reported in the first year.

If a 1031 exchange fails or does not proceed and at the conclusion of the exchange period in year two, the intermediary disburses all cash proceeds from the original year one sale and the exchanger can defer paying tax for a year. They have the benefit of reporting income on their year two tax returns but must use IRS Form 6252 to report an installment sale in the year of the sale. This is the default method under Section (j)(2) a one-year tax deferral, unless the exchanger timely elects out of installment sale treatment by filing an election to include the income in the first tax year.[vi] To elect out of the default installment treatment, the sale should be reported using Form 8949, Form 4797 or a combination of the two forms. The election should be filed by the due date of the year one tax return, considering any extensions. In some cases, it may be more beneficial to include the gain in year one if the exchanger has losses or other tax credits that they can use to offset or shelter the gain. Any cash received at sale in year one or used to pay for ineligible expenses (i.e. credits to buyer for operational items like tenant deposits, utilities, among others), is cash boot in the year of the sale.[vii] The actual receipt of the cash will be recognized as income in year one.  If the exchange ends in year two, gain from the receipt of remaining funds held by the QI at the end of the exchange or any other boot (non-like kind property) received in the exchange is reported in year two unless the taxpayer makes a timely election. Filing a tax return reporting the gain in year one may constitute an election that is irrevocable without consent of the IRS.[viii] For additional information regarding the reporting procedure, Forms and other considerations, see IRS Publication 537.

The Interest Cost of Deferring Gain Beyond $5 Million in Installment Sales – Tax straddles with cash boot in year two may face interest on deferred tax liabilities. Section 453A(c) states that if the installment obligations are over $5 million in a tax year, the exchanger pays interest on the excess amount. This reduces the benefit of deferring gain from a large 1031 exchange to the second year. IRC §453A(c) explains how to calculate the deferred tax liability. It is the unrecognized gain on the principal balance at year-end times the tax rate for the exchanger. For real estate gains over $5 million, calculating tax liability usually includes a mix of the following rates 20% for long-term capital gains, 25% for unrecaptured Section 1250 depreciation, and the 3.8% Net Investment Income Tax.

The interest rate on the amount of deferred tax liabilities is the same as the underpayment rate in §6621(a)(2), which is 8% per year, compounded daily (as of October 1, 2023). The interest accrued on large tax straddles can be significant. For example, a $10 million tax straddle would accrue over $400,000 in interest on the $5 million excess. Exchangers with a large tax straddle should consider this additional cost and consider opting out of the installment sale method under §453(d).

 Accounting for Debt in Tax Straddles:

Revenue Ruling 2003-56 and Rev. Rul. 94-4 could create tax traps for the unaware. Rev. Rul. 2003-56 introduces a notable disparity for 1031 exchanges that span two tax years. It analyzes how a tax straddle affects partnership accounting when a tax partnership relinquishes property encumbered by debt in year one and replaces it with property encumbered by debt in year two. This Ruling offers two examples concerning partnerships engaged in tax straddles, highlighting the application of partnership accounting principles. These principles are designed to accurately reflect the tax positions of partners at the end of a year. However, they present a challenge in the case of a partial 1031 exchange that straddles two tax years, where all debt from the sale is not replaced with debt on the replacement property in year two. Rev. Rul. 2003-56 draws upon the principles of partnership deemed distributions as outlined in Rev. Rul. 94-4. This latter ruling establishes that a decrease in a partner’s share of debt liability is essentially treated as a draw or a deemed distribution by the partnership under §752(b) to the extent of the partner’s distributive share of partnership income for year one. Notably, the tax consequences of this deemed distribution are not recognized immediately. Instead, they are accounted for at the end of the partnership’s tax year.[ix] A net increase in partner’s share of the partnership liability in year two, using the Section 1031 debt netting rules is accounted for under §752(a) in the year in which the encumbered replacement property is acquired.

For general background regarding debt netting in a 1031 exchange, see our detailed article here.

The accounting intricacies highlighted in Rev. Rul. 2003-56 underscore the importance for partnerships and individual partners to keep their tax returns open. This can be achieved by filing for an extension until the exchange is fully concluded. Failing to do so means that if the tax year is already closed, they would not be able to net any debt that is replaced with replacement property debt in the second year. The mechanics of partnership taxation, as applied by Revenue Ruling 2003-56 and Rev. Rul. 94-4, introduce complexities in reporting tax straddles. It is imperative for tax professionals to comprehend these nuances to ensure accurate and compliant tax reporting for partnerships engaged in these transactions.[x]

This article is intended as a resource to facilitate an informed discussion between an exchanger and their tax and/or legal advisors regarding the treatment of a 1031 exchange tax straddle. Therefore, it is critical that a taxpayer speak with their tax and/or legal advisors regarding the accounting aspects and tax consequences of their exchange.

Endnotes

 [i] Treas. Reg. § 1.1031(k)-1(j).

[ii] See Christensen v. Commissioner, T.C. Memo 1996-254, 71 T.C.M. (CCH) 3137.

[iii] See In re Dilaurenti, No. 829357, 2020 N.Y. Tax LEXIS 186 (N.Y. Div. Tax App. Nov. 27, 2020). (holding that the law requires strict compliance with procedure; the exchanger’s failure to timely file a request for an extension, resulted in an exchange period shorter than 180-days).

[iv] Smalley v. Comm’r of Internal Revenue, 116 T.C. 450, (2001)

[v] The exchanging taxpayer believed that a two-year timber rights extraction contract relinquished was like kind to land and standing timber acquired in the exchange.

[vi] See Section 453(d)(1) and 453(d)(2) regarding the election and manner of election; see also Private Letter Ruling, PLR-133834-17 (discussing a 1031 exchange tax straddle and the manner of timely election and revocation of the election).

[vii] An ineligible expense is any item not considered a capital expenditure with respect to the relinquished property.  For an in-depth discussion, see Legal 1031’s short Article “What Transactional Costs can I Pay with my 1031 Exchange Funds” linked here.

[viii] See PLR-133834-17.

[ix] Treas. Reg. § 1.731-1(a)(1)(ii)

[x] For in depth technical discussion regarding the implications and applicability of Rev. Rul. 2003-56, see Richard M. Lipton, Multi-Year Deferred Like-Kind Exchanges by Partnerships – Is the New Rev. Rul. A Trojan Horse?, J. Tax’n, Aug. 2003; see also Bradley Borden, The IRS’s Position on Section 1031 Straddle Exchanges is Half Wrong, Tax Notes, Nov. 13, 2023.

Legal 1031 Exchange Services LLC and Legal 1031 EAT Holdings, LLC do not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended, or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein. Information in this article and linked herein may not constitute the most up-to-date legal or other information. We recommend that taxpayers and their advisors independently analyze the benefits and risks of their 1031 exchange and those of related tax strategies.

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