January 9, 2023
By: Julia Mastrotto, Esq., Counsel
If I have already closed on the sale of real estate, is it too late to structure my transaction as a 1031 exchange?
In short, a taxpayer transacting a 1031 exchange (“exchanger”) should always engage a qualified intermediary (“QI”) prior to the sale of real estate in order to properly structure the transaction as an IRC Section 1031 exchange. Once a sale takes place, the exchanger is generally out of luck if they have yet to engage a QI at that point – this is due to the concepts of “actual” and “constructive” receipt. This article seeks to provide exchangers with information regarding both forms of receipt and their significance in a successful tax-deferred exchange.
“Receipt” refers to the receiving of funds, whereas the terms “actual” or “constructive” refer to those funds being received physically (actual receipt), or those funds being deemed received even though not obtained in actuality (constructive receipt). Once an exchanger or their agent has an “unrestricted right” to sale proceeds, they have likely lost the opportunity to structure their transaction as a valid 1031 exchange due to constructive receipt of the proceeds. Actual or constructive receipt of sale proceeds is a taxable event in the eyes of the IRS. Even in situations where at closing, funds were deposited in a third-party’s escrow account and remained untouched after the sale, a taxpayer may still be in constructive receipt of funds. To have a valid 1031 exchange, a qualified intermediary (“QI”) must be assigned the seller’s rights to proceeds under the contract and transfer the relinquished property on behalf of the seller, pursuant to an exchange agreement. See Treas. Reg. §1.1031(k)-1(g)(4)(iii)-(vi).
“If the taxpayer’s control of receipt of the money or property is subject to substantial limitations or restrictions, then there is no constructive receipt.”[i] To avoid being in constructive receipt of sale proceeds, money or property, a taxpayer should use a qualified escrow account.[ii] In the 2011 case Crandall v. Commissioner, the Court concluded that funds deposited into a Title escrow account represented constructive receipt of the proceeds because the Title escrow agreement “did not expressly restrict petitioners’ access to and use of the funds held in the escrow account.”[iii] In contrast, an exchange agreement with a QI expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary.[iv] Due to the constructive receipt of funds and lack of the involvement of a QI at the time of sale, the Court deemed that the transaction did not qualify for 1031 nonrecognition.[v]
The concept of the earnest money deposit (“EMD”) is also significant in the context of a 1031 exchange, as we know receiving funds may trigger receipt or nonrecognition issues. However as stated above, “income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.”[vi] In Garcia v. Commissioner, the Court found that the EMD deposited into the escrow account was not deemed received because the deposit was “subject to substantial limitations or restrictions,” pursuant to the escrow agreement.[vii] Therefore, it is critical that if your transaction includes an EMD, you consult with a professional about structuring your exchange in order to ensure the EMD is documented and handled correctly.
For a valid delayed or forward exchange, a QI must be in place prior to the sale of relinquished property to prevent the actual or constructive receipt of funds by the exchanger (otherwise triggering a taxable event). As a rule of thumb, 1031 exchanges cannot be structured retroactively after an exchanger, their agent, or a related party receives the sale proceeds; this also includes the exchanger’s attorney if the proper limitations are not in place.[viii] The best practice is to transfer all sales proceeds directly to the QI and not allow the exchanger’s attorney to hold any proceeds (including deposits held in escrow) for long after the closing.[ix] An attorney holding an earnest money deposit or a hold-back in escrow is usually not considered to be in constructive receipt where the amount in escrow is subject to contingencies; it is still considered a deposit or unsettled item and not sale proceeds – i.e. the seller does not have a vested, unrestricted right to the funds.[x]
Similarly, in the event of a reverse or parking exchange, the exchanger cannot own both the replacement property and relinquished property at the same time.[xi] We sometimes receive questions regarding transacting a reverse exchange on a property that the client has already purchased without engaging an exchange accommodator to hold (aka. “park”) the title. A scenario like this would not qualify for tax deferral under Section 1031 because the exchanger has already received the replacement property prior to commencement of the exchange.
Based on the situation in IRS Info Notice Letter 2020-0025 (released September 25, 2020), every so often the IRS receives the same question that a QI may receive regarding the structuring of an exchange after relinquished property has already been sold. In the Notice, the IRS responds to a taxpayer’s question regarding the applicability of the 2020 Covid-19 extensions provided to taxpayers conducting an exchange during the height of the pandemic. The taxpayer thought that the extension might have applied to the timing of the start of an exchange. However, the extensions only applied to the 45-day identification period and the 180-day exchange period. The IRS explained the rules to the inquirer but also emphasized the importance of using a QI to structure their exchange.
Under the law, if an exchanger actually or constructively receives proceeds from a transfer of the taxpayer’s relinquished real property before receiving “like-kind” replacement real property, the transaction is a sale and not an exchange as required by IRC Section 1031. This sale treatment applies even though the exchanger may ultimately acquire “like-kind” replacement real property.
Based on the limited information provided in this short letter, it appears that the exchanger did not engage a QI and instead accepted the sales proceeds themself (actual receipt). The disconnect appears to be that the taxpayer was not aware of the issues surrounding actual or constructive receipt, and instead believed that only the identification of replacement property started the exchange – this is inaccurate.
In Wo Yee Hing Realty Corp. v. Stern, a taxpayer was unable to affect a 1031 exchange because they were in actual receipt of the sale proceeds. Consequently, the taxpayer suffered a $5.1 million dollar tax liability.[xii] The taxpayer attempted to sue their transactional attorney for legal malpractice, alleging the attorney’s purported failure to properly advise the client on constructive receipt, ultimately leading to a lost opportunity to conduct a valid exchange. The Court found that the attorney had advised the client that the exchange was not within the scope of his representation and that he was unfamiliar with Section 1031, so properly structuring the exchange would fall on the responsibility of the client and their accountant. Furthermore, at the closing, the exchanger insisted that the sale proceed checks be made out to them, with a note “for the purpose of the 1031 exchange,” despite concern expressed by both their attorney and the purchaser’s attorney. The exchanger had never engaged a QI to prepare exchange documents, and instead received the funds (actual receipt) prior to depositing them in a qualified escrow account held by a QI.
There are several other examples of caselaw wherein taxpayers attempted to sue their attorneys for actual or constructive receipt issues.[xiii] Avoid that scenario altogether by remembering to always consult with your accountant or tax advisor regarding the tax ramifications of your exchange prior to effectuating the same.
- Communicate and start the discussion early. If you plan on selling real estate and the 1031 exchange option interests you, talk to a QI about your transaction (preferably long before you sell). If you are proceeding with a 1031 exchange, ensure a QI is in place and the paperwork is finalized to structure the transaction as an exchange.[xiv] You should also make sure that the closing agent is aware of the exchange, has received the QI instructions, and is in contact with the QI. While the QI cannot act as an advisor, an experienced QI is a valuable resource that can help keep the exchange on track and ensure it is properly structured. In Wo Yee Hing Realty Corp. it was clear that the exchanger had not spoken with nor engaged a QI when they had insisted that the check for sales proceeds be made out to them, accompanied only by a comment regarding an exchange.
- Work with the right professionals. Putting the right team on the field will greatly benefit the exchanger who is seeking to take advantage of a 1031 tax-deferred exchange. Not all attorneys are exchange experts, and neither are all accountants. Be certain that your transactional advisors are well-versed in 1031 exchanges, and most importantly, ensure they are aware that you intend on re-investing your sale funds in replacement real estate by utilizing an exchange.
[i] Sec. 1.1031(k)-1(f)(2), Income Tax Regs.
[ii] Crandall v. Commissioner, No. 29479-08S, 2011 Tax Ct. Summary LEXIS 14, at *5-6 (T.C. Feb. 15, 2011).
[iii] Id. at *7.
[iv] Treas. Reg. §1.1031(k)-1(g)(4)(ii).
[v] Crandall supra at *8.
[vi] Garcia v. Commissioner, 80 T.C. 491, 500 (1983).
[viii] See Treas. Reg. §1.1031(k)-1(k)(2).
[ix] Treas. Regs. §1.1031(k)-1(g)(4)(ii) & (g)(6) provide that to have a valid exchange, the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period must be expressly limited by agreement (a QI must effectively limit how and when the taxpayer can receive proceeds). Sections (g)(3) to (g)(5) of the Regulations provide additional “safe-harbors” relating to the intermediary and qualified escrow arrangements.
[x] “If the sale is consummated, it fixes the seller’s right to retain the deposit, and the earnest money is included as part of the sales proceeds.” Ahadpour v. Commissioner, No. 4843-96, 1999 Tax Ct. Memo, at *16-17 (T.C. Jan. 21, 1999); citing, Kang v. Commissioner, T.C. Memo 1993-601.
[xi] Or in the case of structuring an improvement exchange, own the title to the land or property to be improved if the improvements are to be included in the exchange. See e.g. Kreisers Inc. v. First Dakota Title Ltd. P’ship, 2014 S.D. 56, 852 N.W.2d 413; see also PLR 200251008.
[xii] 949 N.Y.S.2d 50; 2012 N.Y. App. Div. LEXIS 5719.
[xiii] See e.g.; Chang Yi Chen v. Zen Huang; 43 Misc. 3d 1207(A); 990 N.Y.S.2d 436; 2014 N.Y. Misc. LEXIS 1495.
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