Real Estate Transactions: It’s All in the Timing

By James Brennan, Managing Director & Corporate Counsel, Exchange Solutions Group L.L.C.

Commercial real estate executives often experience increased transaction velocity around year’s-end. Whether it is the company’s tax year or an external impetus driving a transaction, such as a counter party’s tax year, the end result is the same: Executives end up contemplating the advantages and disadvantages of structuring end of the year like-kind exchanges.

This issue is even more critical in our current legislative environment with tax policy changing “mid-stream” in an exchange. In this article we discuss two often missed tax planning points that revolve around timing of 1031 Exchanges: failed Section 1031 exchanges and the need to timely file for an extension if a taxpayer’s 180-day timeline in a 1031 Exchange is cut short by April 15, 2011.

In the case of a failed or partial tax-deferred like-kind exchange transaction, a taxpayer may be able to defer his capital gain (or some portion thereof) into the 2011 tax year rather than the income tax year in which the relinquished property closed. With so much focus on the Bush tax cuts and a potential extension on Capitol Hill right now, it would be prudent for taxpayers to give themselves flexibility with a variety of tax scenarios they could face in 2011. Taxpayers could face no changes in 2011 or they could face higher capital gains rates. The ability to “elect the most favorable treatment” is ideal.

For example, say a calendar-year taxpaying entity sells a $15 million dollar asset on December 10, 2010, and is not sure whether or not he or she wants to do a 1031 Exchange. If the taxpayer cashes out in 2010 and does not do a 1031 Exchange, the answer is simple: He or she will be taxed in 2010 at prevailing rates upon disposition. However, if the taxpayer sells an asset and makes the asset part of a like-kind exchange in 2010 and the proceeds are held with a Qualified Intermediary, the tax implications instantly change from the prior scenario. The taxpayer would “go out hunting” for replacement property and be confined by the 45th day which would land in January, 2011. If he is successful finding eligible replacement property, there are no tax consequences (assuming he closes within 180 days); however, if the client does not find suitable replacement property the tax issue becomes when does he get access to his proceeds.

The ability to defer the recognition and reporting of the taxable gain into the following income tax year depends on when the taxpayer has the right to obtain access to or receive the benefit from his 1031 Exchange funds.

To repeat, if a taxpayer disposes of his relinquished property as part of a 1031 Exchange and the relinquished property disposition closes on December 10, 2010, the 45th and 180th day will hit in 2011. The 45th and 180th days are the only opportunities for taxpayers to “get their proceeds back” from a Qualified Intermediary under the 1031(g)(6) limitations under the regulations.
If the taxpayer has not identified any like-kind replacement property within the 45 calendar day identification period the capital gain income tax liability could be recognized in the following income tax year pursuant to the installment sale rules under Section 453 of the Internal Revenue Code because the taxpayer did not have control or access to the funds until 2011 (the earliest opportunity- his 46th day).

The taxpayer can elect to recognize and report the capital gain income tax liabilities in either 2010 or 2011 at his or her discretion.

A related point is that the taxpayer needs to be mindful of these year-end 1031 Exchanges. If April 15th comes first, a taxpayer must file for an extension to get the full 180 days. The final month of 2010 can be a pivotal tax planning opportunity for year-end taxpayers executing real estate transactions.