A recent IRS private letter ruling serves as a reminder that a failed exchange that starts in one year and fails in the following year can be reported as an installment sale. This permits an investor to defer paying tax on gain from the sale of real estate to the following year, even though the exchange has failed.

For example, an investor enters into an exchange agreement with a qualified intermediary and the sale of his relinquished property closes on September 1, 2007. The investor identifies one replacement property and is unable to close on the purchase of that property before the end of the 180-day exchange period, which occurs on February 28, 2008. Since the investor has been unable to complete his exchange, the intermediary will send him the exchange proceeds in 2008. The investor will owe tax on the gain from the sale of that property; however, the tax will not be due in the 2007 tax year. The investor will pay tax on the gain when he files his 2008 tax return.

In the recent private letter ruling, the taxpayer sold its relinquished property via a qualified intermediary near the end of "Year 1." The taxpayer was unable to acquire replacement property and received its exchange proceeds the following year. The taxpayer's accountant overlooked that the sale of the relinquished property in Year 1 qualified for the installment method of reporting, and reported the gain in Year 1. The taxpayer eventually learned that the gain could have been deferred to Year 2 due to the installment sale rules. In the ruling, the IRS permitted the taxpayer to retroactively revise the allocation of gain so that the gain could be applied to Year 2.

References: Private Letter Ruling 200813019; Reg. § 1.1031(k)-1(j).