Year End Exchanges
Exchanges that commence in one tax year and end in a subsequent tax year are sometimes called Year End Exchanges. These so called Year End Exchanges contain some unique benefits and some hidden pitfalls which include:
The need to apply for an automatic extension to file if the exchange period ends after the date for filing the tax return for the tax year in which the transfer of the relinquished property occurs.
The right to elect to defer the recognized gain in a failed or partially taxable exchange to the subsequent tax year.
The ability to terminate the exchange by prematurely filing the tax return for the tax year in which the transfer of the relinquished property occurs.
The exchange period begins on the date the taxpayer transfers the relinquished property to a buyer and ends at midnight on the earlier of the 180th day thereafter or the due date, including extensions, for filing the taxpayer’s tax return for the taxable year in which the transfer of the relinquished property occurs. For example, if a calendar year taxpayer transfers the relinquished property on December 13, the exchange period will end on the due date for filing, typically, April 15, unless the taxpayer applies for an automatic extension to file. If the request for an automatic extension is filed, the exchange period will end at midnight on June 11, 180 days after December 13.
The IRS challenged the exchange arguing that the replacement property was not acquired within the exchange period. The Taxpayer argued that the acquisition occurred within the 180 day exchange period, and that the exchange complied with the provisions of IRC §1031.
Unfortunately the taxpayer lost. Because the taxpayer filed the tax return for the tax year of the sale of the relinquished property on April 15, the position of the IRS that the exchange terminated on April 15 prevailed. The property acquired on May 12 was deemed not to be like kind to the relinquished property and did not qualify for the taxpayer exchange.
The exchange terminated prematurely on the date of filing of the tax return.
Any property acquired after the termination of the exchange is deemed to be non-like kind to the relinquished property. The property does not qualify for the exchange.
The 180 day exchange period does not apply.
Gain was recognized in the exchange effective on the date of filing of the tax return.
As a practical example, on November 27, a taxpayer transferred title to real property in a transaction intended to qualify as a Tax Deferred Exchange under IRC §1031. On April 15, 139 days after the transfer of the relinquished property, the taxpayer filed the tax return for the tax year in which the transfer of the relinquished property occurred. Later, on May 12, the taxpayer acquired the replacement property and reported the transaction as an exchange.
If the taxpayer had applied for an automatic extension to file, the exchange would not have terminated until May 26, the property acquired on May 12 would have qualified as replacement property in the exchange, and the IRS would not have prevailed.
The tax attributes of an exchange are reported to the IRS on FORM 8824 which is filed with the taxpayer’s tax return for the tax year of the year of sale of the relinquished property. The information that is reported on FORM 8824 includes, but is not limited to, the realized gain, the gain recognized in a partially taxable exchange or failed exchange, the gain deferred because of the application of the exchange provisions and the tax basis of the replacement property.
If gain is recognized in a Year End Exchange, the taxpayer may elect to report the amount of the recognized gain shown on FORM 8824 by the installment sale method and treat the gain as received in the tax year after the year of sale of the relinquished property. In the above example, the exchange terminated on April 15. The taxpayer will file FORM 8824 with the year of sale tax return and report recognized gain in the exchange.
For tax purposes, the gain was recognized on April 15, the date the exchange terminated. Since the taxable gain was recognized at the time of termination of the exchange, the taxpayer may make an election on the year of sale return to treat the gain under the installment sale method and postpone the recognition of the gain to the following year.
In a similar transaction, a calendar year taxpayer entered into a bona-fide exchange on December 1. On January 15, the exchange failed and was terminated by virtue of the fact that the taxpayer was unable to identify any replacement property to be acquired in the exchange. The taxpayer may elect to report the recognized gain from the failed exchange by the installment sale method and defer the tax liability to the subsequent tax year.
A further example, a taxpayer entered into an exchange on December 1. On January 2, the taxpayer successfully identified qualified replacement property. The identification was made prior to the termination of the identification period on January 15. On March 1, the taxpayer determined that the identified property contained significant structural problems and terminated the agreement with the seller. Because the taxpayer had identified replacement property, the exchange could not be terminated until the end of the exchange period, which would occur on the earlier of the date the taxpayer filed a tax return for the year of sale of the relinquished property or the 180th day after December 15 if the taxpayer filed for an automatic extension to file.