When initiating a 1031 Exchange in the latter part of the year, an intriguing option to consider is "tax-straddling”. Successful completion of the exchange allows taxpayers to defer taxes and reap the benefits inherent in the 1031 Exchange. Conversely, should the exchange falter and remain unfinished, taxes become due. However, an advantageous aspect for these taxpayers is the potential qualification for a "mini-tax deferral" through tax straddling, affording them the opportunity to report and settle their taxes on their 2024 tax returns rather than immediately on their 2023 tax returns.
Delving into the technical mechanics of tax straddling, let's envision a scenario where a taxpayer initiates a 1031 Exchange at the close of 2023, typically after October 17th, but the exchange proves unsuccessful. Consequently, taxes on the gain from the sale must be paid. If the funds retained by the 1031 intermediary are not returned to the taxpayer until after December 31st, the attempted exchange spans into 2024. This circumstance triggers an Installment Sale under IRC Section 453 (and the 1031 regulations). With tax straddling, the taxpayer has two alternatives:
The taxpayer can opt to report the taxable gain on the tax return for the year in which the property was sold (2023). OR
Alternatively, the taxpayer can report the taxable gain on the tax return for the year in which they gained possession of the sale proceeds (2024). By selecting option B, the taxpayer effectively enjoys a de facto one-year tax deferral on the gains from the property sale.
This choice results in a one-year tax deferral of the gain from the property sale. Tax straddling becomes an enticing incentive for investors concluding investment property sales at year-end, assuring that the IRS does not penalize them for attempting a 1031 Exchange. The prospect of a one-year deferral serves as a compelling contingency plan for those undertaking such exchanges.
Taxpayers are strongly advised to consult with their tax advisors as tax straddling does not universally apply to all sales. Gains associated with debt relief are recognized in the sale year, and a bona fide intent to exchange is imperative for installment sale treatment eligibility.
Check with your tax and legal advisors to ascertain your eligibility for these advantageous tax-deferral methods.
