What happens if an exchange fails

The ways an exchange fails

Several distinct events can cause an exchange to fail. The most common is running out of time: no property is identified in a signed writing sent to a permitted recipient, usually the qualified intermediary, by midnight of day 45, following the identification rules, or property was identified but none of it is acquired by day 180. An identification can also be defective on its own terms, delivered to the wrong party, unsigned, or too vague to identify a specific property, which has the same effect as identifying nothing at all.

Separately, an exchange fails if the exchanger receives, pledges, borrows against, or otherwise obtains the benefit of the exchange funds before the exchange period ends. That direct or constructive receipt is exactly what the safe-harbor regulations are built to prevent. An exchange can also fail at the outset if the party holding the funds does not qualify as an independent intermediary, for example because it held one of the relationships described as disqualifying in the guide to what a qualified intermediary does.

The consequence: a taxable sale

When an exchange fails, the transaction is not penalized beyond losing the deferral; it is treated as what it would have been without section 1031, a sale. The gain on the relinquished property is recognized under the ordinary rules: capital gains tax, depreciation recapture, the net investment income tax where it applies, and any state tax on the gain, all computed on the gain, that is, the amount realized less adjusted basis. The guides to depreciation recapture and boot cover two pieces of that computation that also apply here.

When the qualified intermediary may return the funds

Under Treas. Reg. §1.1031(k)-1(g)(6), an exchange agreement that preserves the safe harbor must restrict the exchanger's rights to the exchange funds until specific events occur. The intermediary may release funds to the exchanger: after day 45 if the exchanger identified no replacement property; after the exchanger has received all of the identified property the exchanger is entitled to acquire; after the end of the exchange period, meaning day 180 or the earlier tax-return due date described in the guide to the 45- and 180-day deadlines; or, after the end of the identification period, on a material and substantial contingency that relates to the exchange, is provided for in writing in the exchange agreement, and is beyond the control of the exchanger and of any disqualified person (other than the seller of the replacement property).

Outside of those triggers, the intermediary cannot simply return the money because the exchanger has decided to abandon the exchange, however clearly the deal has fallen apart. An exchange agreement that allowed the exchanger to call for the funds at will would give the exchanger the kind of control over the proceeds that defeats the safe harbor, not only for that exchanger but as a matter of how the agreement is written. That is why qualified intermediaries hold to the (g)(6) triggers even after an exchanger's identified deals have all collapsed well before day 180.

The straddle rule

When a relinquished property sale closes in one tax year and the exchange fails so that the qualified intermediary returns the funds in the following year, Treas. Reg. §1.1031(k)-1(j)(2) generally allows the exchanger to report the gain under the installment method, in the year the funds are actually received, rather than in the year of sale, provided the exchanger had a bona fide intent to complete the exchange at the start of the exchange period. The regulation treats the exchanger's right to the funds, contingent on the exchange failing, as a form of deferred payment. An exchanger who prefers to recognize the gain in the year of sale rather than waiting for the following year may elect out of installment treatment.

Partial failure and boot

An exchange does not have to fail completely to produce tax. If the exchanger acquires some, but not all, of the property identified, and the remainder of the exchange funds is returned as cash, the acquired property is treated as a successful exchange to that extent, and the returned cash is boot, taxable up to the amount of gain realized. The guide to boot covers how that calculation works.

Reporting

A successful or partially successful exchange is reported on IRS Form 8824 with the return for the year the relinquished property was sold. When the straddle rule applies and the gain is reported under the installment method, Form 6252 is also used to compute and report the installment gain in the year the funds are received.

What does not rescue a failed exchange

A few common instincts do not fix a failed exchange. Buying a property that was never identified in the signed 45-day writing does not qualify as replacement property, even when the purchase closes well within 180 days. An identification delivered after day 45, for any reason, is late regardless of how close the deal that fell through came to completing. And there is no mechanism to roll the funds from a failed exchange directly into a new exchange; once the exchange period for the original sale ends, the funds are simply distributed, and any later purchase is a separate transaction made with after-tax dollars.

Practical fallbacks

Two practices reduce the chance that a single deal's collapse turns into a full failure. The first is identifying backup property within the 45 days rather than a single candidate: the exchanger can identify up to three properties regardless of value, or more under the 200 percent rule described in the identification rules, so a second or third identified property remains available if the first purchase does not close. The second is naming a Delaware statutory trust interest as one of the identified properties. Beneficial interests in a DST structured under Rev. Rul. 2004-86 can qualify as like-kind replacement property; they are securities offered through licensed broker-dealers, and onezero3one does not sell, recommend, or evaluate any DST offering. Where an exchange is genuinely at risk of failing, the exchanger's tax advisor can also plan in advance around the straddle rule described above, including whether electing out of it would be preferable.

Sources

• Treas. Reg. §1.1031(k)-1(g)(6) (permitted release of exchange funds) and §1.1031(k)-1(j)(2) (installment-method treatment).
• Internal Revenue Code §453 (installment method) and §1031.
• Rev. Rul. 2004-86 (Delaware statutory trust interests as replacement property).
• IRS Form 8824 and Form 6252 and their instructions.