The year 2005 saw taxpayers exchanging with greater frequency, but how many of them prepared in advance for an unsuccessful 1031 exchange outcome? Under certain circumstances, advanced preparation can afford an unsuccessful 1031 client with an otherwise forgone tax deferral. This article’s purpose is to assist third and fourth quarter 2006 taxpayers with an exchange hedging tool, which I like to refer to as Tax Straddling (“TS”).

Tax Straddling
TS allows for the coordination of Internal Revenue Code (IRC) Section 1031 with that of IRC Section 453. The coordination of these sections grants a mini-tax deferral by triggering gain recognition in the year that the exchange fails, rather than the year in which the property was relinquished. Therefore, if a 2006 exchange process fails within the Tax Straddling Approach’s (TSA) window of opportunity, then the taxpayer can potentially defer paying the tax until 2008!

Why?
The taxable gain, rather than being recognized in 2006, when the property was relinquished, is recognized and reported in the failing year of 2007. The 2007 tax is paid when the 2007 tax return is filed in 2008.

To prepare for this potential mini-tax deferral, the TSA uses, to its advantage, the two time periods that constrain the exchange process by structuring the 1031 client’s sale of its relinquished property to occur on a date that will allow the Identification Period and/or the Exchange Period to elapse in the following tax-year that the exchange process commenced.

Define these periods.
The Identification Period is that period in which the 1031 client must identify the like-kind replacement property that is being targeted for acquisition. It is a 45-calendar day period. While the Exchange Period runs in tandem with the Identification Period, this period allows for the 1031 client to actually acquire the identified replacement property. The most days that this period grants the 1031 client is 180-calendar days, but sometimes it can be less. For instance, if the 1031 client’s tax return due date precedes the 180th day, and the 1031 client does not file for a tax return extension, then the Exchange Period elapses at midnight of the tax return filing date. Both of these time periods begin ticking the day that the 1031 client is deemed to have relevantly transferred the relinquished property to the purchaser. Generally speaking, this date is the closing date.

Tax Straddling Windows of Opportunity
Between July 5 and December 31 there are two windows of “tax straddling opportunity” that exist - July 5 through November 16 and November 17 through December 31. Relinquishing between July 5 and November 16 will create a tax straddle only if the 1031 client has appropriately “identified” the replacement property that will be targeted for acquisition during the Exchange Period. Fulfilling the identification requirement is vital because an exchange that lacks this required step, during this window, will cause the exchange to fail in 2006. Once the identification process is completed, the 1031 transaction will either allow for the successful acquisition and deferral of gain or the unsuccessful completion of the exchange attempt. If unsuccessful, the failure will occur in 2007 because the intermediary holding your 1031 funds will be unable to release them to you until the Exchange Period has elapsed. The elapsing of course occurs in the desired year of 2007. While the July 5 through November 16 window commits a 1031 taxpayer to the “long haul,” the November 17through December 31 window, in contrast, does not. Here, a failing 1031 taxpayer does not need to identify in order for the exchange to straddle into 2007 because the 45-calendar day Identification Period overlaps into 2007!

Caveat 1031 Client
The 1031 client must pass a “bonafide” intent requirement prior to being able to coordinate IRC Section 453 with that of IRC Section 1031 in an effort to receive the mini-tax deferral. The 1031 client should confer with his CPA or attorney to ensure that he has passed this test.

If you are required to make quarterly tax payments in accordance with the Estimate Payment Rule, then it is best that you discuss this approach with your CPA. More than likely, this rule will dilute, if not wash away, the tax straddling benefit.

If you are a partnership, then your CPA should be reviewing Revenue Procedure 2003-56. Simply stated, this Procedure will require, that the gain that is attributable to the relief of debt, when the relinquished property was disposed (sold), be recognized in the year that the property was relinquished. The theory being that the relief of debt is equivalent to the receipt of cash. Since this benefit of cash must be recognized in the year in which it was received, the tax straddling approach may only be applicable to the 1031 equity (net proceeds) that is escrowed with the intermediary.

So, there are failures and then there are survivors! Which are you? SLDT