In recent years, the tax law has encouraged like-kind exchanges of real property by providing an incentive to defer taxable gain on the sale and using a replacement property to rollover gain. Some of the steps needed for a like-kind exchange include a 45-day period to identify any replacement property, completing a reinvestment transaction within 180 days and using a QI (qualified intermediary) to maintain any proceeds from the property sale in an escrow account. With the real estate market becoming volatile and mortgage rates increasing with inflation, it may not be a surprise it is becoming more difficult to complete an exchange with these limits.
Recent tax legislation has added some more issues upon the sale of personal and real property, making tax results more unclear if the exchange is not completed. Beginning January 1, 2018, Section 1031 like-kind exchange tax deferral no longer applies to exchanges of tangible personal property. Under the Tax Cuts and Jobs Act, only real property will qualify for tax deferral in a like-kind exchange, and whether the gain on the sale is taxable now or deferred by reinvestment.
Regardless of the timing of the sale and the scope of the gain, this summary provides some issues if the exchange fails and the taxable gain must be reported. Your preparation and careful tax planning may help determine whether the closing of the sale has significant tax issues.
Related Read: Related Parties' Property Exchange Does Not Qualify as Like-Kind
NEED TO DETERMINE THE TAXABLE GAIN
The gain on real estate is based on the original purchase price and related improvements and capitalized costs, and the original tax basis may need to be adjusted for the depreciation over the asset life. If the sale is simply for the real estate alone, then the seller may have a choice whether the proceeds are all realized and the gain will be taxable at lower tax rates. If the seller is either a pass-through entity or an individual, taxable gain may be eligible for long-term capital gain rates (15 or 20%) if the property was held for longer than a one-year period and some gain created from depreciation deductions may be eligible for a 25% tax rate as Section 1250 gain. In this example, the tax rate on the sale may be favorable enough to accept current tax consequences.
NEED TO REVIEW TAX REPORTING RULES
Most tax returns have a special form to disclose a calculation of gain on a like-kind exchange. Form 8824 is attached to the income tax return for the year in which the transfer of real estate occurs. The form includes both the taxable gain on the sale and any deferred gain that will be used to adjust the cost of the replacement property for a future sale. There are additional issues if property is sold to a related party or if the property may have been used as a personal residence. In order to complete the form, replacement property needs to be received either 180 days after you gave up your property, or by the filing due date of the tax return for the year you transferred your property, whichever is earlier. This includes any extensions. By doing so, the IRS expects you to report the proper gain on the exchange even if you need to file an extension to complete the exchange.
NEED TO EVALUATE INSTALLMENT SALE ISSUES
Many taxpayers assume that a transaction is fully taxable in the year of sale if no exchange occurs. If all of the gain is from real estate, then there may be a choice to reinvest all or part of the proceeds into like-kind real property and defer the gain until a subsequent sale occurs. If the like-kind exchange fails, then it is possible that proceeds held in escrow may not have been available until the next tax year. The timing of any sales proceeds may be delayed and eligible for an installment sale method. An installment sale occurs when at least one payment is not received until after the end of the year in which the taxable disposition occurs.
Certain taxable transactions may be recognized on an installment method basis to report gain as the proceeds are received. The installment gain is allowed to be deferred to match the timing of the proceeds. Since the deferral does not apply to ordinary gains, the tax consequences of the character and timing of gain are very critical to qualify for any tax deferral and benefits of a sale.
CONSIDER THE BENEFITS OF TAX STRADDLING
However, if that exchange fails and is not completed, some taxes will be due. The benefit for those taxpayers is that they may still qualify for a "smaller deferral" (via tax straddling) where they can report and pay some taxes on their following tax return instead of immediately on their current tax return. The portion eligible for deferral is the amount reported as an installment gain. For example, most mortgage balances are settled at the sale closing date, so any proceeds used to pay off a mortgage will not qualify for a deferral and reinvestment into a replacement mortgage. The receipt of taxable "boot" includes any "unlike" property received in any taxable exchange. Cash, personal property or a reduction in the mortgage owed after an exchange are all boot and subject to tax. The ordinary gain on a sale will also be taxable in the same year as the sale. For this reason, it will be important to compute the tax benefit under either method and assess results. The benefit may be less helpful if the tax will otherwise be payable through estimated tax or if the tax rates in the next year are greater due to reporting more income in the future.
CONSIDER THE SCENARIOS AND OPTIONS
Of course, choosing the best option is important if you have a real estate transaction that requires negotiation for both the sale and the reinvestment. It is best to determine how much time and help is needed to work through the process, and whether you have considered all of your options.
Related Read: Properly Structuring a Like-Kind Exchange
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
