The 1031 Exchange Institute

Welcome to The 1031 Exchange Institute™. The 1031 Exchange Institute is your complete online resource for 1031 exchange, 1033 exchange, 1034 exchange, 721 exchange, 453 installment sale and 121 exclusion information.  Information will also be provided regarding Self-Directed IRAs, including Traditional IRAs, ROTH IRAs, SEP-IRAs and SIMPLE IRAs. 

The 1031 Exchange Institute is dedicated to educating and informing real estate investors and their advisors on the benefits of 1031 tax-deferred exchanges and other tax deferred and tax exlcusion strategies so they can make better informed investment decisions.

Releasing 1031 Exchange Funds Early

Investors generally enter into a written 1031 Exchange Agreement with a 1031 exchange Qualified Intermediary with the intention of completing the 1031 exchange by acquiring like-kind replacement property and deferring the payment of their capital gain taxes.

However, things do not always go as planned.  So, what happens if the investor can not locate suitable replacement property to acquire or simply changes his or her mind and instructs the 1031 exchange Qualified Intermediary to cancel the 1031 exchange and disburse the 1031 exchange funds held to the investor? 

History

The most commonly used safe harbor created by the 1991 treasury regulations establishes and defines "qualified intermediaries" (1.1031(k)-(1)(g)(4)). The vast majority of exchange transactions are now closed under the qualified intermediary safe harbor. Under the 1991 regulations, a "qualified intermediary," as defined under the safe harbor, is not considered to be the agent of the taxpayer for 1031 purposes. In order for a taxpayer to effectuate a 1031 exchange using the "qualified intermediary" safe harbor, the taxpayer and intermediary must enter into a written exchange agreement prior to the sale of the relinquished property. The exchange agreement sets forth the terms and conditions under which the 1031 transaction is structured. The exchange agreement must provide that the qualified intermediary acquire the relinquished property from the taxpayer and transfer this relinquished property to a third party buyer and acquire the replacement property from a third party seller and transfer this replacement property to the taxpayer. The exchange agreement must also specifically limit the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the relinquished property sale proceeds prior to the expiration of the exchange period. This restriction on use of funds is comprehensive and is often called the "(g)(6) limitations." See Treas. Reg. 1.1031(k)-(1)(g)(6). The (g)(6) limitations must remain in effect throughout the entire exchange period.

The exchange period begins on the date that the benefits and burdens of ownership of the relinquished property is transferred (generally the closing date) and ends on the date of the earliest occurrence of one of the following events:

1. After the end of the identification period, if the taxpayer has not identified replacement property before the end of the 45-day identification period (i.e., Day 46); or
2. After taxpayer has received all of the identified replacement properties to which taxpayer is entitled; or
3. If the taxpayer identifies replacement property, after of the end of the identification period and the occurrence of a material and substantial contingency that: (a) relates to the deferred exchange; (b) is provided for, in writing, and ( c) is beyond the control of the taxpayer and of any disqualified person, other than the person obligated to transfer the replacement property to taxpayer; or
4. At the end of the 180-day exchange period.

A taxpayer can elect to structure a 1031 transaction outside the qualified intermediary safe harbor, and thereby avoid entering into a written exchange agreement with the mandatory (g)(6) limitation language. taxpayer will also lose the benefits and the protection afforded by the safe harbor, and will risk not only the probability of having his transaction set aside by IRS, but of also facing penalties and interest payments. An attempted 1031 transaction that is set aside by IRS as a failed exchange will be significantly more expensive to a taxpayer than if that same taxpayer simply sold his relinquished property outright, and paid the capital gains tax. So, for those taxpayers who wisely elect to structure a 1031 transaction under the qualified intermediary safe harbor, they also "elect" to comply with the (g)(6) limitations. It is clear, however, that many taxpayers do not fully understand the magnitude of these (g)(6) limitations.

MYTHS AND MISCONCEPTIONS ABOUT THE (G)(6) LIMITATIONS

Myth #1

Taxpayer can cancel an exchange anytime between Day 1 and Day 45 by simply demanding return of all exchange funds from the qualified intermediary.

Fact #1

There is absolutely no provision for a taxpayer who has entered into an exchange agreement with a qualified intermediary to receive money or other non-qualifying property prior to the end of the 45-day identification period.

In order for a taxpayer to structure a 1031 transaction and take advantage of the 1991 safe harbor which authorizes the use of a qualified intermediary, the safe harbor requires a written exchange agreement that contains, among other things, specific (g)(6) limitations on taxpayer's ability to receive or control the exchange funds. If a written exchange agreement does not set forth the (g)(6) limitations, the safe harbor is not satisfied, and the intermediary is not a "qualified intermediary."

A non-qualified intermediary could be deemed to be the agent of the taxpayer, and as such, would not be eligible to provide exchange services including holding relinquished property sales proceeds. If the "holding party" is not protected by a safe harbor, and is deemed to be the agent of the taxpayer, under agency common law provisions, an agent acts on behalf of its principal (the taxpayer), and as such, it would actually be the taxpayer who was "holding" the relinquished property sales proceeds. If a taxpayer actually receives or controls or even has the right to receive or control the relinquished property sales proceeds, the "sale" does not qualify for 1031 non-recognition treatment, and the attempted exchange fails.

Therefore, if a taxpayer intends to complete a 1031 exchange, and enters into a written exchange agreement with a qualified intermediary, then the written exchange agreement must contain certain restricting language regarding the use and control of all of the exchange proceeds. The mandatory restrictions must be in effect from the time that relinquished property is closed until the exchange period terminates. Taxpayer cannot elect to terminate the exchange period. The exchange period terminates only upon the occurrence of the specified events.

Events that terminate the exchange period are clearly defined by the Treasury regulations and do not include a voluntary election by taxpayer. The earliest termination event is Day 46, if taxpayer has not identified replacement property. Thus, the Treasury regulations make no provision for terminating an exchange agreement before Day 46, and the written exchange agreements of all qualified intermediaries mirror this requirement.

Myth #2

Taxpayer has identified 3 properties, and subjectively intended to close on only one of the three properties. Since taxpayer successfully closes on one of the three identified properties on Day 60, and used most of the exchange proceeds for this acquisition, taxpayer can demand the immediate return of the remaining, unused exchange funds.

Fact #2

Under the (g)(6) limitations, the exchange period for a taxpayer who has identified replacement property does not terminate until the taxpayer has received all of the identified replacement property to which he is entitled to receive under the written exchange agreement. A taxpayer is entitled to receive all the properties that he identifies. Therefore, if a taxpayer identifies three properties, he is entitled to receive three properties. And, until the remaining two properties are purchased, the exchange period does not terminate. Taxpayer cannot receive money or other non-qualifying property from the qualified intermediary, until the exchange period terminates. A taxpayer cannot demand return of the "excess" proceeds until Day 180 or until taxpayer acquires the other two replacement properties. Therefore, a taxpayer who intends to purchase only one of the identified properties should clearly state this intention on the identification by simply adding the phrase "one of the following three properties," or by using the word "or" between the three identified properties. Then, when the taxpayer acquires one of the properties, he has acquired all of the identified replacement properties to which he is entitled. The exchange period is terminated and taxpayer is entitled to receive all "excess" exchange funds at that time.

Myth #3

If taxpayer is unable to purchase the identified replacement property due to an inability to negotiate a contract for the purchase, this taxpayer can demand immediate return of his exchange funds based on a "material and substantial contingency that is beyond the control of the taxpayer."

Fact #3

The "material and substantial" contingency exception set forth in the (g)(6) limitation has a very narrow application. First, this terminating event is available only after a taxpayer has identified replacement property and the 45-day identification period has expired. Thus, a taxpayer cannot claim "material and substantial contingency" before day 45. Although not specifically defined, Treasury does set forth several examples of events that would be considered "material and substantial contingencies," such as: the replacement property is destroyed, stolen, seized, requisitioned or condemned, or a determination is made that the regulatory approval necessary for the transfer of replacement property cannot be obtained in time for the replacement property to be transferred to the taxpayer before the end of the exchange period. See Treas. Reg. 1.1031(k)-(1)(g)(8) Example 2. In addition, this material and substantial contingency must: (1) relate to the deferred exchange; (2) be beyond the control of taxpayer and any disqualified person; and (3) be in writing.

While the term "regulatory" is not further defined in the regulations, the majority of scholars deem that regulatory is synonymous to governmental. What is also well accepted among scholars is that it is the Internal Revenue Service's position that an economically unfeasible event does not satisfy the "material and substantial contingency beyond the control of taxpayer" requirement. If a taxpayer decides that the asking price of an identified replacement property is too high, or if the identified replacement property is no longer on the market, the Internal Revenue Service has taken the position that such events are not beyond the control of taxpayer who theoretically could acquire the property (albeit at an economically undesirable price) or could force the sale of the identified replacement property by an otherwise reluctant owner by simply offering an excessive price. Economic conditions, or contingencies are deemed not to be "beyond the control of taxpayer," and therefore, do not amount to "material and substantial contingencies" which result in termination of the exchange period. Anything that is within the taxpayer's control, wherein the taxpayer must decide whether to meet a seller's demands, or walk away from an unacceptable business deal, does not amount to a "material and substantial contingency," under the (g)(6) limitation.

Myth #4

To ensure good customer service, all exchange agreements contain the (g)(6) limitations, but many intermediaries will ignore enforcing these provisions of the exchange agreement.

Fact #4

A qualified intermediary, who is economically reliable and reputable, has an appreciation for compliance with the safe harbor requirements. This qualified intermediary's written exchange agreement contains mandatory language including (g)(6) limitations, which ensures safe harbor compliance. If a qualified intermediary routinely amends its written exchange agreement, or fails to follow the specific terms of its written exchange agreement, the Service could make a convincing argument that the qualified intermediary's standard "actions" in effect amended the terms of the written exchange agreement, and such agreement, as "amended," fails to contain the mandatory (g)(6) limitations. Therefore, this qualified intermediary would not be within the safe harbor, and all the exchanges in which this intermediary participated, could be invalid. Reputable qualified intermediaries who are in the business of structuring and documenting 1031 transactions have a great appreciation for operating with the clearly stated regulations and guidelines that define the safe harbor.

"All other qualified intermediaries" do not authorize early termination of exchange agreements or return exchange funds to taxpayers simply based on a taxpayer's demand. A qualified intermediary can provide excellent customer service by ensuring that its documents and actions comply with Section 1031 of the Code, and the regulations promulgated thereunder. Taxpayers should be clearly advised of the (g)(6) limitations before entering into an exchange agreement. Many qualified intermediaries highlight the specific (g)(6) language in their exchange agreements, and have the taxpayers either initial the language or sign a separate paragraph acknowledging the (g)(6) limitations.

CONCLUSION

Since the introduction of the regulations in 1991, taxpayers have confidently structured 1031 transactions to comply with the qualified intermediary safe harbor created thereunder. Qualified intermediaries have assisted millions of taxpayers in successful completion of 1031 transactions. But, in order to do so, a qualified intermediary's written exchange agreement must include language which limits the taxpayer's control of the relinquished property sales proceeds. These mandatory (g)(6) limitations must remain in effect until the exchange period terminates. Once a taxpayer begins an exchange under the qualified intermediary safe harbor, he has virtually no ability to "change" his mind and demand return of his funds until the exchange period is over. At the earliest, the exchange period is over on Day 46, if the taxpayer has not identified replacement property. At the latest, the exchange period is over after midnight on Day 180. Qualified intermediaries as well as tax attorneys and advisors can best serve their taxpayer clients by highlighting the (g)(6) limitations. A well-informed taxpayer may continue to be "frustrated" by the (g)(6) limitations, but such a taxpayer should not be "surprised" or outright belligerent.