A 1031 exchange is one of the most powerful ways for real estate investors to defer capital gains taxes. But sometimes, even with the best planning, things don’t go as expected.

Investors often ask:

“What happens if I sell my property but can’t identify or acquire a replacement property in time? Does my exchange fail?”

The short answer is: yes, the exchange fails — but you may still be able to defer taxes.

One option is to convert the failed exchange into an installment sale under IRS Section 453.

This approach doesn’t eliminate taxes but can allow you to spread the gain over time, avoid a large one-year tax hit, and keep much of the original tax planning intact.

Here’s how it works.

1. What Happens When a 1031 Exchange Fails?

A 1031 exchange can fail for two common reasons:

1. You can’t identify suitable replacement property within 45 days, or
2. You identify property, but cannot close within the 180-day deadline.

If either deadline is missed, the exchange becomes fully taxable… unless you have structured the sale in a way that allows you to elect installment sale treatment.

This is where Section 453 can create real value.

Converting a Failed 1031 Exchange Into an Installment Sale

If the exchange deadlines are missed, you may be able to treat the transaction as an installment sale and defer recognizing the gain until payments are received.

The general process looks like this (simplified):

1. The property is sold and proceeds flow through the Qualified Intermediary (QI)

Even if the exchange later fails, the QI must handle the transaction from the start.

2. You attempt the 1031 exchange but cannot close in time

At Day 46 or Day 181, the exchange is considered failed.

3. You elect installment sale treatment on your tax return

This allows you to recognize the gain as payments come in, instead of all at once.

4. The buyer makes payments under an installment note

The note must include:

• A market-rate interest rate
• A payment schedule over at least two tax years
• Security backed by real property
• Proper IRS reporting (Form 6252)

5. You recognize gain only as the payments are received

Interest income is taxed annually, but the capital gains portion is spread over the duration of the note.

6. You may still be able to complete a 1031 exchange later

If you eventually acquire qualifying replacement property, you may be able to exchange the installment note for the new property and continue deferring gain.

This is highly technical and depends on timing and structure — but it can be done under the right circumstances.

Benefits of Using an Installment Sale After a Failed Exchange

A failed 1031 exchange doesn’t have to result in an immediate tax bill. An installment sale can offer several advantages:

1. Continued Tax Deferral

Instead of paying all capital gains in one year, you recognize gains as payments come in, often over several years.

2. Greater Flexibility

You are not locked into the 180-day exchange deadline. Proceeds can be deployed into other investments, not just like-kind real estate.

3. Opportunity for a Future Exchange

If you later find suitable property, the installment note may be used in a subsequent 1031 exchange.

4. Reduced Risk of Losing the Transaction

If you cannot find a replacement property, you still maintain tax deferral and avoid a large year-one tax burden.

Drawbacks to Consider

While installment sales help preserve tax efficiency, there are trade-offs:

1. Interest Income Is Taxable Each Year

While the gain is deferred, interest payments are taxed annually as ordinary income.

2. Buyer Default Risk

If the buyer stops making payments, your timing and tax plan may be disrupted.

3. Increased IRS Scrutiny

Failed exchanges followed by installment treatment must be structured cleanly and correctly. Poor documentation can trigger audits.

4. Limited Reinvestment Options

Proceeds cannot be reinvested into non-like-kind assets without recognizing some income. The flexibility exists, but it must be managed carefully.

5. Loss of Full 1031 Benefits

An installment sale does not eliminate taxes completely. It simply spreads them over multiple years.

Is Using an Installment Sale After a Failed Exchange Right for You?

A failed 1031 exchange can feel stressful — especially when the tax bill is large. But an installment sale can provide a meaningful fallback strategy that smooths out the tax impact and keeps your planning on track.

Some investors prefer the simplicity and tax efficiency of converting a failed exchange into an installment sale. Others may choose to explore additional options like:

• Delaware Statutory Trusts (DSTs)
• 721 UPREITs
• Opportunity Zone Funds
• Bonus Depreciation Funds
• Oil & Gas Funds

The right path depends on your timing, liquidity needs, tax exposure, and long-term goals.

At Wealthstone Group, we help investors evaluate these strategies side-by-side so they can understand how each option affects taxes, cash flow, and long-term planning. If you’re dealing with a failed 1031 exchange or want clarity on your alternatives, we’re here to help you make an informed and confident decision.

Considering a 1031 Exchange?

To learn more about leveraging a 1031 exchange for tax deferral, download our free e-book today!

General Disclosure

Please note that this information is for informational purposes only and does not constitute individual investment advice. It should not be relied upon as tax or legal advice. Consult the appropriate professional regarding your individual circumstances.

Diversification does not guarantee profit or protect against loss in a declining market. It is a method used to help manage investment risk.

Investing in DST properties and real estate securities involves material risks such as liquidity, tenant vacancies, market conditions, competition, interest rate risks, and the risk of losing the entire investment principal. DST 1031 properties are available only to accredited investors and accredited entities. Verify your accredited investor status with your CPA and attorney.

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only. Securities offered through Arkadios Capital, member FINRA/SIPC. Advisory Services offered through Arkadios Wealth. Wealthstone Group and Arkadios are not affiliated through any ownership.