When selling an investment property with the intent of completing a 1031 exchange, deferring capital gains and depreciation taxes in order to reinvest the proceeds in a like-kind real estate investment is the primary benefit.

There are many other additional benefits, but when the sale of the original property happens near year-end, tax considerations take center stage.

The calendar may influence the amount of time an investor has to successfully complete the exchange, dictate the forms that need to be filed, and if the exchange falls through, decisions on when to pay the required taxes must be made.

Knowing the rules up front might help the process go smoothly.

What happens when the exchange is completed?

When a 1031 exchange is successfully completed, capital gains and depreciation taxes are deferred, but a Like-Kind Exchange Form 8824 must be filed with the IRS. The form asks investors for a description of the relinquished property and the replacement property, the closing dates, and the name of the qualified intermediary who facilitated the transaction in addition to other details.

When the tax-filing deadline is approaching

When the exchange is on track to be completed, but the relinquished property sold within 180 days of the tax filing deadline, investors face a dilemma.

The exchange will need to be completed by the current-year tax-filing deadline, even if it is closer than the 180 days from the sale of the relinquished property a 1031 exchange allows. This puts increased pressure on investors to close on the replacement property in what often can be shortened timeframes.

However, exchangers can find relief from this situation if they file for an extension. Individual investors will use IRS Form 4868, Application for Automatic Extension, and Businesses or Corporations will use either Form 7004 or 1138 depending on the specific circumstances.

The key is, if your exchange is not completed by the due date of your tax return — YOU NEED TO FILE AN EXTENSION.

As explained by one widely recognized 1031 exchange facilitator:

“If the 180th day following the closing of your first relinquished property falls after the due date for your 2020 tax return (this year, for individuals, April 17, 2021), you must file an application for extension of time with the IRS to extend the due date. If you do not file for an extension, you will NOT be able to acquire any replacement property in your exchange after your tax return due date.”

What happens if the exchange falls through?

A 1031 exchange can fall through for a number of reasons, such as failure to identify a property within 45 days after the sale of the original property or failure to close within 180 days of the original sale.

In the case of failing to close within the 180-day timeframe, the investor incurs a tax liability on the profit and depreciation recapture, not accounting for property improvements and sales costs. The year in which those taxes are due depends on the date the relinquished property sold and the date on which possession of the proceeds takes place.

If the investor is not able to successfully complete the exchange and it falls through in the new year (2021), the investor has a tax-straddling option in which they can decide whether they want to pay taxes as part of their current-year filing or whether they wish to defer taxes until the following year. This mini deferral option is available as long as the investor had the intent of completing the 1031 exchange.

Having a replacement property back-up plan

It should be noted that having a Delaware Statutory Trust (DST) as a replacement backup plan may help decrease the chances of a failed 1031 exchange. A DST is a passive investment in which shares of a trust are owned and it is often possible to quickly complete the transaction thus avoiding missed deadlines.

When it comes to 1031 exchanges, there are many decisions to navigate. We always recommend consulting a tax specialist who will understand your individual situation. Contact us if you have questions or want additional details about the role a 1031 exchange might have in your real estate investment portfolio.