November 4, 2022
By: Julia Mastrotto, Esq., Counsel
In an IRC Section 1031 exchange, the exchanger has 45 days from the date of sale to identify replacement property, and up to a total of 180 days to close on identified property (or until the date their tax return is due, including extensions, for the tax year in which the earliest transfer occurred, whichever date is earlier). Managing these timelines, both the 45-day identification period and the 180-day exchange period, are critical factors in completing a successful deferred exchange.
With such strict timelines, exchangers have many questions:
At the beginning of the exchange – when does the clock officially start ticking? We sometimes hear about situations where an exchanger believes they can delay the exchange clock from starting by simply not recording the deed or holding it in escrow until they are ready to start the process. We have also encountered situations where exchangers debate whether the date on a closing statement, the date of the funds transfer to the qualified intermediary, or the date of the deed recording, controls the start of the exchange – this generally happens in the context of escrow closings.
Near the end of the exchange period – did I receive my replacement property on-time to have a valid exchange? If the replacement property closing needs to be delayed, how will a “dry closing” affect my 1031 exchange?
Another common question is whether a taxpayer can initiate a 1031 exchange in a situation where no exchange agreement was in place yet, and where the closing agent still has proceeds from the sale of the relinquished property in escrow, but has not distributed them to the seller– in essence, was there in fact a sale, even though funds were not distributed yet?
The above scenarios loop back to one common question:
At what point does the sale or transfer of real property actually occur?
The short answer is that tax law generally defines a “sale” as being complete at the time that the “benefits and burdens of ownership” transfer from the seller to the buyer. This does not necessarily mean that the deed must be recorded in order to constitute a sale; in fact, a taxpayer looking to establish that they sold the property on a certain date might have a valid argument that the transfer had occurred several days before the recording of the deed. Likewise, a taxing authority could potentially argue the same in an effort to refute a taxpayer’s position that a sale had not occurred until the deed was recorded. The primary factor here is at what point the taxpayer will be deemed to have received the “benefits and burdens” of owning the property.
The term “sale” is given its ordinary meaning for Federal income tax purposes and is generally defined as a transfer of property for money or a promise to pay money.[i]
The lead issue of whether the “benefits and burdens of ownership” of property have transferred starts with the seminal case on the issue, Grodt & McKay Realty, Inc. v. Commissioner.[ii] Of course, Grodt & McKay Realty, Inc. has nothing to do with 1031 or real estate (cattle sale), but in its analysis the Court applies tax law principles to the transfer of property. There has never been a case analyzing whether a transfer of real estate occurred specifically for the purposes of a section 1031 exchange, so Grodt & McKay Realty, Inc. has become the go-to test for tax practitioners on this issue.
As stated in the above case, the key to deciding whether the transactions are “sales” is to determine whether the benefits and burdens of ownership have passed. The same is a question of fact which must be ascertained from the intention of the parties as evidenced by the written agreements read in light of the attending facts and circumstances.[iii]
Some of the factors which have been considered by Courts in making this determination are:[iv]
- Whether legal title passes[v];
- How the parties treat the transaction[vi];
- Whether an equity was acquired in the property[vii];
- Whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments [viii];
- Whether the right of possession is vested in the purchaser[ix];
- Which party pays the property taxes[x];
- Which party bears the risk of loss or damage to the property[xi]; and
- Which party receives the profits from the operation and sale of the property.[xii]
Moreover, Treasury Regulations §1.1031(k)-1(g)(4)(iv)&(v) provide that an intermediary is treated as acquiring and transferring relinquished or replacement property if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with the owner of the relinquished or replacement property for the transfer of that property and, pursuant to that agreement, the property is transferred.[xiii]
According to the Court in Yelencsics v. Commissioner, for the purpose of Federal income taxation, “a sale occurs upon transferring sufficient incidents of beneficial ownership rather than technical requirements for the passage of title under State law.”[xiv] Moreover, the “retention by a seller of formal attributes of ownership does not preclude the finding of a sale.”[xv]
Considering the above, we may conclude that the recorded date of deed transfer is not particularly significant in terms of when the sale or transfer of real property actually occurred. Instead, the above factors are weighed more heavily in determining when exactly the “benefits and burdens of ownership” passed. It should be noted that in most cases, the date of the closing (not the date of recording) will be the date that the clock starts ticking.
[i] Commissioner v. Brown, 380 U.S. 563, 570-571 (1965).
[ii] Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981).
[iii] See Calloway v. Commissioner, 135 T.C. 26, 33 (2010). See also Arevalo v. Commissioner, 124 T.C. 244, 251-252 (2005), affd. 469 F.3d 436 (5th Cir. 2006).
[iv] Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237-38 (1981). See also Calloway v. Commissioner, 135 T.C. 26, 34 (2010). See also Arevalo v. Commissioner, 124 T.C. 244, 252 (2005), affd. 469 F.3d 436 (5th Cir. 2006).
[v] Commissioner v. Segall, 114 F.2d 706, 709 (6th Cir. 1940), cert. denied 313 U.S. 562 (1941); Oesterreich v. Commissioner, 226 F.2d 798, 802 (9th Cir. 1955).
[vi] Oesterreich v. Commissioner, supra at 803.
[vii] Haggard v. Commissioner, 241 F.2d 288, 289 (9th Cir. 1956); Oesterreich v. Commissioner, supra at 803; see Mathews v. Commissioner, 61 T.C. 12, 21-23 (1973), revd. 520 F.2d 323 (5th Cir. 1975), cert. denied 424 U.S. 967 (1976).
[viii] Wiseman v. Scruggs, 281 F.2d 900, 902 (10th Cir. 1960).
[ix] Wiseman v. Scruggs, supra at 902; Commissioner v. Segall, 114 F.2d 706 [*1238] at 709 (1940).
[x] Harmston v. Commissioner, 61 T.C. 216, 229 (1973), affd. 528 F.2d 55 (9th Cir. 1976).
[xi] Harmston v. Commissioner, supra at 230.
[xii] Harmston v. Commissioner, supra at 230. See generally Estate of Franklin v. Commissioner, 64 T.C. 752 (1975), affd. on other grounds 544 F.2d 1045 (9th Cir. 1976).
[xiii] 26 CFR § 1.636-3(c): Transfer. The term transfer means any sale, exchange, gift, bequest, devise, or other disposition (including a distribution by an estate or a contribution to or distribution by a corporation, partnership, or trust).
[xiv] Yelencsics v. Commissioner, 74 T.C. 1513, 1527 (T.C. 1980) (citations omitted). See also Gaggero v. Commissioner, No. 21378-03, 2012 Tax Ct. Memo, at *16 (T.C. Nov. 29, 2012).
[xv] Yelencsics v. Commissioner, 74 T.C. 1513, 1527 (T.C. 1980) (citations omitted). See also Gaggero v. Commissioner, No. 21378-03, 2012 Tax Ct. Memo, at *16 (T.C. Nov. 29, 2012).
Legal 1031 Exchange Services, LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of your exchange transaction. Property owners must consult their tax and/or legal advisors for this information. Our role is limited to serving as qualified intermediary to facilitate your exchange.
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