Saving A Failed Exchange

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We occasionally get a client who, for one reason or another, is unable to complete their exchange, usually because they cannot find suitable replacement property. If they don’t identify ANY replacement property, their exchange ends at midnight on the 45th day. We return their funds to them the next day and they pay tax on the sale. If they DO identify replacement property by the 45th day, their exchange continues until either: A) they purchase their new property, or B) their replacement period expires on the 180th day. If they don’t purchase, their exchange funds are then returned on the 181st day. Again, their sale is taxable because they did not complete the exchange.

A 1031 exchange can fail due to an assortment of causes. One scenario is when a client is unable to find a suitable replacement property, or the replacement property fails inspection. But they don't want it to fail because the tax will diminish their proceeds, which diminishes their non-real estate investment. For example, if the proceeds from your sale are $100,000, and the tax is $30,000, you'll only have $70,000 left to reinvest.

...Yes Virginia, there’s a solution for all three of these scenarios...

Another scenario involves the sale of a business. Exchanges involving businesses can be complicated. You can easily do a 1031 exchange for the real estate, but if you sell the equipment you must buy similar equipment as your replacement property. And you cannot 1031 exchange “blue sky” or goodwill. For this reason, few business sales involve 1031 exchanges.

A third scenario involves the sale of large homes. The IRS allows you to exclude $250,000 ($500,000 if you’re married) of the gain from taxation. However, it is not uncommon for large residences to involve gains far in excess of $500,000. While these transactions don’t involve 1031 exchanges, is there an alternative for those homeowners other than paying the tax? Is there an alternative for the real estate investors and business sellers other than paying the tax?

Yes Virginia, there’s a solution for all three of these scenarios. It’s called a ‘Deferred Sales Trust,’ and it’s similar to a Charitable Remainder Trust, but much more flexible. It works like this: you set up a trust into which you transfer your property. The trust sells the property (or closes the sale you’ve already negotiated) and invests the proceeds. You get to determine how the proceeds are invested, and you can determine when and how much of the proceeds are distributed to you. You might get a monthly installment, like an annuity, and increase or decrease the amount of each installment according to your needs. If you already have regular income, you can elect to not take installments and allow the earnings to compound until you retire. Then you can begin to draw installments. Unlike a Charitable Remainder Trust, the entire balance of the trust is paid to you or your heirs.

So, by putting the property you’re selling into this Deferred Sales Trust (or if you are mid-stream in a 1031 exchange and you transfer the exchange into this Trust), you will have navigated around the previous problem scenarios we listed:

  • Not be able to find a suitable ‘new’ property, or
  • Having to find the nearly exact same type of business, or
  • Having too much gain on the sale of your home, etc.

As in everything, there’s always a catch. Here, the catch is that each installment you take is taxable – not all of it, but part of it. Each installment is partially a tax free return of basis, part taxable capital gain (from the appreciation of your property), and part earnings from the invested cash (whether that be interest, dividends or capital gains). The tax rate on the capital gains and the earnings are at the rate in effect when you receive the installment. These rates change from time to time, but you always know ahead of time if Congress is going to change them. If you anticipate a large increase, you can take a sizable distribution from the trust in order to pay tax at the current lower rate. Alternatively, if you anticipate tax rates will go down, you can defer current distributions until after the rate decrease in order to pay tax at the lower rate later. Or, if you have a large investment or capital loss in your personal return, you can trigger an equal amount of distribution from the trust, resulting in essentially tax-free cash.

There are some other catches or caveats as well: If there’s (accelerated) depreciation on the property you have to recapture that and pay tax on it outside of the trust. And if you’re in the middle of an exchange and decide that you want to go the direction of this Trust, your Intermediary can now transfer your exchange to the trust which will avoid immediate recognition of the gain and let you spread the tax over the period you choose. But Qualified Intermediaries are not allowed to set up both your trust AND your exchange, so you’ll have to get your attorney to set the trust up for you. Just make sure you work with a trust attorney or an estate planning attorney that has experience in this area.

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