What to do when a 1031 exchange overlaps years

Suppose Fred and Sue sell their bare lot on September 30, 2005 for $100,000 and buy a gorgeous red condo on February 15, 2006 for $90,000, completing their exchange. They have bought down by $10,000, and as a result they have $10,000 of proceeds left over. This money is returned to them by their intermediary after the close of their exchange. When is the $10,000 taxable? In 2005 when they sold the land? Or in 2006 when they received the check from the intermediary?

Because you have 180 days after the sale of the Old Property to complete the purchase of your New Property, this is a much more common occurrence than you would think. In effect, all exchanges that are completed in the second half of the year have the potential to fall into this scenario. Although most people either complete their exchange before the end of the year, or they are buying up and using all of their exchange proceeds, for a large number of exchangers the "buy-down after years end" scenario this is a common question.

So when is the $10,000 taxable? The correct answers are: "2005," "2006" and "whenever you want it to be." Boot is what the IRS calls the "taxable part" of a 1031 exchange. There are two types of boot, and the type of boot affects the answer.

Let's talk about cash boot first. Fred and Sue sell the land for $100,000 cash and buy the red condo for $90,000 cash. There is $10,000 of cash left over, and this is called cash boot. When Fred and Sue receive this cash in a different tax year than when they sold the land, the IRS automatically imposes installment sale rules, which require that the cash be taxed when it is received -- in other words, in 2006, the second year.

...There are two types of boot, and the type of boot affects the answer...

However, by making a formal election on their 2005 return (the year of the sale), Fred and Sue can specifically choose to pay tax on the $10,000 in the year of the sale. Why would they do this? Well, there could be a variety of reasons. For one, their tax rate might be much higher in the second year. Or perhaps they have a loss carryover from a prior year that will expire in the year of the sale and they want to take advantage of it. Whatever the reason, with a little tax planning, Fred and Sue may actually choose which of the two years they want the gain to be taxed.

Their election to pay tax in the first year rather than the required second year must be made in a timely filed tax return. This is where things can get interesting. Fred and Sue could properly extend the filing of their 2005 income tax return until October 16, 2006 (October 15th is a Sunday). In other words, they can go more than a year past the sale of the land, and almost to the beginning of year-three before they decide whether they want the $10,000 gain to be taxed in their year-one or year-two tax return.

Fred and Sue lose some or all of their flexibility if there is depreciation recapture involved in the transaction. Let's say that they sold a purple duplex instead of a bare lot, and they had taken $4,000 in depreciation while they owned it. The depreciation recapture is taxable in year one, the year of the sale, and the $6,000 balance would have been subject to the installment sale rules. If they had taken more than $10,000 in depreciation, they would have no flexibility and all of the gain would be taxable in the year of sale.

That's cash boot. Now, let's talk about debt boot, which is what the IRS calls the "taxable part" when you buy down, and spend all of the cash, but get a smaller loan on the New Property than you paid off on the Old.

Assume that Fred and Sue had a $40,000 mortgage on the bare lot, which was paid off when they sold it. The balance of $60,000 then goes to their qualified intermediary. Fred and Sue used all of these proceeds, along with a new loan of $30,000 to buy their red condo (for $90,000). They paid off a $40,000 mortgage and obtained a new $30,000 mortgage in a transaction where they bought down by $10,000, thus creating debt boot. When you have debt boot, in a transaction that crosses year ends, the gain (the boot) is always taxable in the year of the sale. They would have no choice but to pay tax on it in year-one.

So, to summarize the answer to the question of when Fred and Sue must pay tax on the gain, the possible correct answers really are "2005," "2006," and "whenever they want it to be."