1031 exchange – Installment sale treatment

Using a qualified intermediary (“QI”) can be an effective tool to give a property owner the choice of the year in which to recognize a gain, even if the exchange is not completed. The regulations under Section 1031 are very specific as far as setting forth the requirements and duties of QIs. One such requirement is that once the replacement properties are identified within the first 45 days, the QI is required to hold onto the cash until the earlier of acquisition of replacement property, or 180-days after the sale of the relinquished property. To provide property owners relief, the regulations also provide that the cash received in a subsequent year can be treated as proceeds from an installment sale. By parking proceeds with a QI the property owner may defer the gain to the subsequent year. This actually gives the property owner flexibility to decide in which year to recognize a gain. It can be in the current year, by electing out of installment sale treatment, or in the subsequent year by not electing out of installment sale treatment. Besides the obvious time value of money considerations, delaying the gain can also be a good idea heading into a year, such as 2017, with expected decreases in tax rates. Another less common scenario we have seen, but can be very important to consider, is when a taxpayer has Section 1231 losses.

As you probably know, when you sell business assets you generally get the best of both worlds; losses are treated as ordinary and gains are treated as capital. What may be overlooked is that net Section 1231 losses are subject to recapture for 5 years. In other words, if a taxpayer has a net Section 1231 loss in year one and then has a net Section 1231 gain in year 3, the year 3 Section 1231 gain is taxed as ordinary to the extent of the previous Section 1231 losses taken. So, if a taxpayer is sitting on the 5th year of a large Section 1231 loss recapture and is selling a Section 1231 asset in the last 6 months of the year the use of a QI should be considered to defer the gain and avoid this sting. There are other matters to bear in mind though. First, when recognizing gains under the installment method the tax rate that applies is the tax rate for the year in which you recognize the sale, not the rate in effect in the year that the sale occurred. It is also important to note that there are depreciation recapture provisions under the installment sale rules. Therefore, if a taxpayer has taken accelerated depreciation on an asset which is sold, the taxpayer is required to include the accumulated depreciation as ordinary income, to the extent of the gain, in the year of the sale. This does not apply to what is referred to as “unrecaptured 1250” depreciation; i.e. straight-line depreciation. So, on most real property, this does not apply. However, we have recently seen a greater potential for this current income hit to apply due to bonus depreciation on tenant improvements.

Jeffrey M. Lawson, CPA, MST, Stoy, Malone & Company, P.C.

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