A 1031 exchange is a powerful vehicle to build wealth by permitting taxpayers to defer capital gains, and depreciation recapture, through a properly executed transaction. But the rules governing exchanges are a “safe harbor,” meaning that the failure to comply exactly with these technical rules will violate the exchange and force the taxpayer to recognize and pay tax on the gain she was attempting to defer. And doing so years after the exchange, for example when an IRS examiner disallows the transaction due to a technical violation of the rules, could add penalties and interest to the pain of having to recognize (and pay tax on) the gain.
One of the biggest reasons for unintentionally violating these rules, relates to the date by which the taxpayer must actually complete the purchase of the replacement property. A quick example will help.
Example: Frank owns a rental property with 8 units. He sells the rental property on November 15, 2018, and properly executes 1031 paperwork and instructs his settlement agent to transmit the proceeds to a Qualified Intermediary, like e1031xchange. Frank then buys another like-kind property and closes on it on February 1, 2019.
Under the IRS rules, there are two deadlines to be aware of. First, within 45 days of the sale (which happened on November 15) he must identify the property which will be acquired, and inform the qualified intermediary with a list of possible acquisitions (typically the list is limited to 3 properties, although there are other ways to identify which provide more options, and we will address that in future articles). Second, Frank must close on the replacement property within the time allocated by the IRS. And here is where it gets complicated.
Generally, the rule for closing on the replacement property is that it must close no later than 180 days from the date of the sale of the relinquished property. In the example above, the relinquished property closed on November 15, 2018, so 180 days from that date is May 14, 2019. But be careful, the IRS regulations have a minefield here. The exchange is violated if the replacement property (the property Frank is buying as a replacement for the property he sold)
“is received after the earlier of the date that is 180 days after the date on which the taxpayer transfers the relinquished property, or the due date (determined with regard to extensions) for the transferor’s federal income tax return for the year in which the transfer of the relinquished property occurs” (emphasis added to bolded words)
Huh? The regulation accelerates the date by which the exchange must be completed to the earlier of the following two dates: (a) 180 days after sale (e.g. May 14, 2019), and (b) the date that Frank’s 2018 tax return is due, which is April 15, 2019! Suppose Frank is quite efficient, and is ready to file on January 1, 2019 and in fact does file on that date. Now he cannot change the due date by filing an extension. In such a case, Frank will have inadvertently blown the 1031 exchange if he closes on the replacement property after he files his return. Sometimes, efficiency just does not pay!
The easy work-around: Frank’s CPA must avoid filing the 2018 return until the replacement property is acquired. In this example, Frank had until May 14, 2019 to close on the replacement property, if he uses the full 180 days. So if he goes right up to the wire, and does not close until that date, his CPA should pay the tax he owes, and file for an extension for the 2018 tax return prior to the normal April 15 filing deadline in order to avoid tainting the exchange by not closing in a timely fashion.