Using 1031 Exchanges to Shift Gains Between Tax Years

As we start to wind down towards the end of the year, now is a good time to point out that 1031 exchanges are a great vehicle to use in shifting gain between two tax years. For example, if Fred and Sue sell their purple duplex on December 1, 2008, their 45-day identification deadline for their exchange is January 14, 2009. Section 1031 of the Internal Revenue Code requires that they send a list of potential acquisition properties to their intermediary no later than, in this example, this date. Failure to do so will terminate their exchange, causing the gain from the sale of their purple duplex to be taxable.

Let's say Fred and Sue fail to identify any replacement properties before the deadline, and immediately subsequent to January 14, their intermediary returns their exchange proceeds. In what year is Fred and Sue's gain taxable? In 2008 when they sell their property? Or in 2009 when they receive the proceeds check from their intermediary? The correct answer is whichever year they want it to be. How can that be? Let me explain.

...In what year is their gain taxable? When they sell their property, or when they receive the proceeds...

Section 1031 says that if your exchange fails in a different tax year (2009) than the year you sold it (2008), the IRS's installment sale rules kick in. The gain is taxable when you receive the proceeds, which is 2009 in our example. The installment sale rules are automatic, meaning that Fred and Sue have to use them. In other words, Fred and Sue have to treat their gain as taxable in 2009.

However, the installment sale rules also allow you to elect out of them, if you so wish, by filing a statement with your tax return for the year of the sale. So by attaching a statement to their 2008 tax return saying they are electing out of the installment sale rules, Fred and Sue could treat the gain as taxable in 2008 (the year of the sale). Why would they do this? Such an election might make sense if, for example, they had a large loss that was expiring with their 2008 tax return.

So, before they file their 2008 tax return, Fred and Sue could actually tax plan in which year they wanted to report the gain. If they want it to be in 2008, they file the statement and report the gain. Otherwise it will be automatically reported in their 2009.

The election has to be made in a timely filed return. Fred and Sue could actually extend their 2008 return until the last filing date of October 15, 2009, before deciding in which year they choose to report the gain. In other words, they could almost go a year after the sale before they are forced to commit to the year in which the gain would be reported.

Another very popular use of this rule is to delay the payment of tax on year-end sales by a year. Back to Fred and Sue: let's say they have no intention of buying another property. If they sell their property on December 1, 2008 and don't do an exchange, the tax on the sale will be due on April 15, 2009. If they do an exchange, but fail to identify any replacement property, the gain automatically gets shifted to 2009, and the tax on the gain will be due April 15, 2010 -- one year after their tax would be due if they didn't do an exchange.

However, be smart if you use this technique, since the IRS can throw the gain back into 2008 if they think you did the exchange solely to play this game. If you do this, make sure you document your efforts to find an acceptable replacement property.