Failed 1031 Exchange Installment Sale (453 Focus)

Investors sometimes inquire, "What happens to my 1031 Exchange transaction if I sell my relinquished property and cannot find suitable like-kind replacement property to identify, or if I cannot acquire the property that I did identify within the prescribed 180 days' regulations?"

A 1031 exchange with an installment sale allows a seller to defer paying capital gains taxes on the recognition of gain from the sale of an investment property by exchanging the property for a similar investment property and receiving an installment sale note as part of the exchange proceeds. 

However, if the seller cannot acquire the replacement property or properties within the required time frame, the exchange may fail. In this case, the seller may still be able to structure the sale as an installment sale and defer paying taxes on the gain from the sale until the installment sale note is paid off.

Structuring a Failed 1031 Exchange into an Installment Sale 

To structure a failed 1031 exchange into an installment sale, the seller must follow specific steps:

The seller sells their investment property and receives the proceeds, which may include an installment sale note. The seller must work with a qualified intermediary (QI) to handle the exchange.

The seller identifies replacement property or properties within 45 days of the relinquished property's sale, but cannot acquire the replacement property or properties within the 180-day time frame required for a 1031 exchange. This means that the exchange has failed.

The seller elects to treat the sale as an installment sale, meaning they will defer paying taxes on the gain from the sale until the installment sale note is paid off. The seller must make this election on their tax return for the year of the sale.

The seller and the buyer negotiate the terms of the installment sale note, including the interest rate and payment schedule. The note must be secured by a mortgage or deed of trust on real property and must be payable over at least two tax years at a market rate of interest.

The seller assigns the installment sale note to the QI to hold until the note is exchanged for a similar investment property. The QI will hold the note in a separate account until it is exchanged for a similar investment property. The note must meet certain requirements to be eligible for a 1031 exchange, including being secured by real property and payable over a period of at least two years at a market rate of interest (reference IRS form 6252 and IRS form 8824 for tax straddling).

The seller uses the proceeds from the sale to acquire other investments or assets, and defers paying taxes on the gain from the sale until the installment sale note is paid off. The seller must report any interest income on the installment sale note as it is received.

If the seller later acquires replacement property or properties that meet the requirements for a 1031 exchange, they may be able to exchange the installment sale note for the replacement property or properties, and continue to defer paying taxes on the gain from the sale of the relinquished property.

It's important to work with a qualified intermediary and a tax professional when structuring a failed 1031 exchange into an installment sale to ensure compliance with the rules and requirements of the exchange, and to understand the tax consequences of the sale. If the seller has already reported the sale as a failed exchange on their tax return for the year of the sale, they may need to file an amended return to report the sale as an installment sale or they become a taxpayer.

Pros of Structuring a Failed 1031 Exchange into an Installment Sale 

Structuring a failed 1031 exchange into an installment sale can have some advantages for the seller, including:

Deferring taxes: By structuring the sale as an installment sale, the seller can defer paying taxes on the gain from the sale until the installment sale note is paid off. This deferral can provide the seller with more cash flow in the short term, and may allow them to reinvest the proceeds from the sale into other investments or assets without having to pay taxes on the gain.

Flexibility: The seller has more flexibility in how they use the proceeds from the sale, since they are not required to use the proceeds to acquire replacement property within the 180-day time frame required for a 1031 exchange. This can allow the seller to take advantage of other investment opportunities or to use the funds for other purposes.

Potential for a future exchange: If the seller later acquires replacement property that meets the requirements for a 1031 exchange, they may be able to exchange the installment sale note for the replacement property and continue to defer paying taxes on the gain from the sale of the relinquished property.

Reduced risk of losing the sale: If the seller is unable to acquire replacement property within the required time frame for a 1031 exchange, they risk losing the sale and being unable to defer paying taxes on the gain from the sale. Structuring the sale as an installment sale can reduce this risk, since the seller is not required to acquire replacement property within a specific time frame.

It's important to note that structuring a failed 1031 exchange into an installment sale does not eliminate the tax liability on the gain from the sale, but rather defers the taxes until the installment sale note is paid off. 

Cons of Structuring a Failed 1031 Exchange into an Installment Sale 

While structuring a failed 1031 exchange into an installment sale can have some advantages for the seller, there are also some potential drawbacks to consider, including:

Interest income: The seller will receive interest income on the installment sale note as it is paid off, and will owe taxes on that income in the year that it is received. This may reduce the benefit of deferring taxes on the gain from the sale, particularly if the interest rate on the note is high.

Risk of default: If the buyer defaults on the installment sale note, the seller may lose the opportunity to defer paying taxes on the gain from the sale. While the note must be secured by real property, there is still a risk of default, particularly if the buyer experiences financial difficulties.

Risk of audit: Structuring a failed 1031 exchange into an installment sale can be complex, and the IRS may closely scrutinize the transaction to ensure that it meets the requirements for a 1031 exchange and an installment sale. If the transaction is found to be noncompliant, the seller may owe taxes on the gain from the sale, as well as penalties and interest.

Limited reinvestment options: By deferring taxes on the gain from the sale, the seller may be limited in their ability to reinvest the proceeds from the sale, since they cannot use the funds to purchase non-like-kind assets without incurring taxes.

Loss of potential tax benefits: By structuring the sale as an installment sale, the seller may lose the potential tax benefits of a 1031 exchange, such as the ability to defer paying taxes on the gain from the sale indefinitely if they continue to exchange into like-kind properties.

It's important to weigh the potential benefits and drawbacks of structuring a failed 1031 exchange into an installment sale, and to work with a qualified intermediary and a tax professional to ensure compliance with the rules and requirements of the exchange, and to understand the tax consequences of the sale. 

Sera Capital helps clients by acting as a fee-only fiduciary focusing on tax-efficient exit planning. We offer DST 1031 exchange services through special situations where investors could put 1031 real estate into a securitized property while deferring taxes. 

If you have a failed 1031 exchange and you'd like to know more about installment sales and your other investment options, schedule your free 30-minute call today.