Tax Straddles, Which Year to Pay the Taxes?
A "Tax Straddle" occurs when taxable gain from a failed or partial exchange happens in one tax year, but the taxable proceeds representing gain are not received or realized by the taxpayer until the following tax year. If a taxpayer wishes to realize the gain in the following year, a Tax Straddle (1031 Exchange transaction straddling two tax years during the 45 to 180 calendar day exchange period) would effectively accomplish this.
The 1031 Exchange is treated as an Installment Sale under IRC Section 453, allowing the investor to elect tax treatment on taxable gain in the year of the sale or, if desired, the year the proceeds are received by the taxpayer at the end of the exchange period. Careful planning should be done with tax advisors prior to electing a Tax Straddle
Note: Taxable gain created by debt relief from the sale is always taxed in the year of the sale, so please plan accordingly
Tax Straddles are used for various reasons, including:
Anticipation of tax losses in the future
Too much taxable income in the current year
Need for more time to deal with the liability before the end of the year of the sale
How Tax Straddles Work
There are two instances for the Straddle to come into play:
When the exchange period begins late enough in the year (typically AFTER the 186th day of the year), there will be 180 calendar days or LESS left in the calendar year to complete the exchange. If the exchange fails AFTER the 45th day and at least one property remains on the 45-day ID statement, cash remaining in the exchange account must be retained by the Qualified Intermediary until the end of the exchange period (day 180) and returned to the investor on the following business day
If the exchange begins after the 321st calendar day of the year, there will be 45 calendar days or less remaining until the new year. Should the exchange fail or terminate on calendar day 45, the Qualified Intermediary must return the unused funds to the investor on calendar day 46
In both cases, due to Treasury Regulations G-6, cash boot remaining and the gain it represents will be realized in the following calendar year, with the option to elect tax treatment in either the year of the sale or the year of receipt of the proceeds.
Electing Out of Installment Treatment
If a taxpayer prefers to pay their taxes in the year of the sale, they may elect out of the section 453 installment treatment. To do this, report your decision on Form 4797, Form 8949, or both. Avoid reporting on Form 6252. This election must be made by the due date, including extensions for filing of the taxes for the year of the sale.
Remember, advanced planning with your tax, legal, and investment advisors is strongly recommended when contemplating any investment, tax, or legal strategy to ensure it is suitable and your goals can be met by electing such a program.
