The Most Frequently Asked Question in 1031 Exchanges : “When Can I Get My Money Back?”
Written By Diane Schaefer, CES™ and President of Exchange Solutions, Inc., N.Y.
Taxpayers involved in tax deferred exchanges frequently ask the question, “When can I get my money back?” Under IRC 1031, the Qualified Intermediary (QI) must follow certain guidelines and restrict the taxpayer from having control over these funds whether it is actual or constructive receipt.
Actual receipt occurs when sale proceeds are transferred directly to the taxpayer in the form of cash, wire to the taxpayer’s account, a check payable to the taxpayer or a check endorsed by the taxpayer to a third party. Constructive receipt is defined as funds transferred from the sale of the relinquished property to a disqualified party. A disqualified party is a person or entity that is an agent for the taxpayer. A few examples of disqualified parties are the taxpayer’s attorney, real estate broker, accountant, spouse, linear relative or a company in which the taxpayer owns a 50% or more interest in that particular company.
The utilization of a QI, a fourth party, resolves the agency and constructive receipt issues. The QI must abide by the requirements of the safe harbors in order not to be considered an agent of the taxpayer. The safe harbors only survive if there is a written agreement between the taxpayer and the QI detailing the limits of the taxpayer’s rights to the exchange proceeds and both parties adhere to the requirements (reg. section 1.1031(k)1(g)(6)), “the (g)(6) limitations.” The rationale of an exchange is to transfer like-kind property for likekind property; not like that of a sale, wherein a seller transfers property for cash. IRC section 1.1031(k)-1(g)(6) set substantial restrictions and limitations upon the taxpayer’s access to control the proceeds from the sale of the relinquished property.
These limitations also pertain to any interest earned on the exchange proceeds held by the QI. The taxpayer may receive interest or growth factor on these funds as long as the taxpayer’s right to receive such interest is restricted to the same limitations as the exchange proceeds even though such interest will be charged to the taxpayer whether it has been paid to the taxpayer in cash, in property or part of the QIs fee. Furthermore, the taxpayer must still report these funds as interest income.
Under the safe harbors of IRC 1031, the taxpayer’s funds and exchange transaction are protected. For example, the use of an escrow account or qualified trust agreement limits the taxpayer’s right to receive, pledge, borrow or otherwise obtain the benefits of the money before the end of the exchange period (reg. section 1.1031(k)-1(g)(3)). The end of the exchange period can only be one of the following: (i) after the end of the 45-day identification period defined in reg. section 1.1031(k)1(b) (2), if the taxpayer has not identified any replacement property within the identification period; or (ii) after receipt by taxpayer of all identified replacement property to which the taxpayer is entitled under the exchange agreement; or (iii) after the end of the exchange period defined in reg. section 1.1031(k)-1(b)(2). The bottom line is that the taxpayer cannot have control over the sale proceeds or interest accruing on these proceeds until the exchange has been completed or the exchange period has expired. If replacement property is not identified properly or if the identified property is not acquired, then the QI can hold these exchange funds for as long as 180 days from the date of the transfer of the relinquished property. The QI cannot release the funds any sooner or it will be jeopardizing every other taxpayer’s exchange it has handled. If the QI let one taxpayer be in command of the funds, then it is perceived that it allowed the others to have power over their proceeds as well. It would be unethical for the QI to deliberately overlook a key part of the code. And who would want an unethical QI to hold their funds and position their exchange? The QI’s reputation and business will be at stake and possibly scrutinized by the service.