The deferred exchange regulations make explicit four safe harbors you may use to avoid constructive receipt of money or boot. If you use safe-harbor specifications, their use will not be considered in testing to see if you have constructive receipt. That’s why they are called safe harbors. But be very careful: Special restrictions apply when you use safe harbors. Your rights are limited. You must not have the right to receive money or other property until
after you have successfully completed the exchange, or,
you fail the identification or exchange period requirements.
You lose your safe harbor protection to the extent you have the ability or unrestricted right to receive money or other property before you actually receive like-kind Replacement Property. These safe harbors apply only until you have such an ability or unrestricted right.
The secret of a successful deferred exchange is avoiding receipt of money or other property during the transaction. If you receive the cash proceeds from the exchange of your property, you will not qualify for §1031 treatment. While this may sound easy to avoid, it's not. You must overcome the doctrine of “constructive” receipt. The general rules concerning actual and constructive receipt apply to determine if you are in actual or constructive receipt of money or other property before you actually receive like-kind Replacement Property. No regard is given to your method of accounting.
You are in actual receipt of money or property at the time you actually receive the money or property. You are also treated as being in receipt if you receive the economic benefit of the money or property. You are in constructive receipt of money or property at the time the money or property is credited to your account, set apart for you, or otherwise made available to you so you may draw upon it at any time. Or if you can draw upon it if notice of intention to withdraw is given.
You are not in constructive receipt of money or property if your control of its receipt is subject to substantial limitation or restrictions. However, you are in constructive receipt of money or property at the time such limitations or restrictions lapse, expire, or are waived. In addition, actual or constructive receipt of money or property by your agent is actual or constructive receipt by you.
Caution: The actual or constructive receipt rules provided here are only for use in determining whether there is actual or constructive receipt in the case of a deferred exchange. Don't use them for other real estate transactions.
In Leonard W. Sapp and Lola L. Sapp v. Commissioner, T.C. Memo. 1993-211.1, the Court ruled the Sapps did not have to recognize gain on a certificate of deposit in the year taken as part consideration of a real estate exchange. The Sapps agreed to sell real property. The sales price consideration was the exchange of a like-kind real property parcel, cash and a certificate of deposit. The like-kind property parcel received by the buyer was part of a rehabilitation project being arranged by the buyer and was to be partially financed by a development bond. However, as a condition of financing the overall transaction, the financial institutions involved in the transactions required the Sapps to pledge the certificate of deposit as additional security for the rehabilitation project undertaken by the buyer. The sales transaction would not have gone forward without the pledge agreement.
The Court said the certificate of deposit received by the Sapps as part of the proceeds from the sale was pledged as security in an interrelated transaction and was not includible in income because the underlying funds were not actually or constructively received by the Sapps. Release of the certificate of deposit was conditioned upon the buyer's showing that net operating income from its rehabilitation project exceeded 120% of debt service for 12 consecutive months. The Court said this condition was impossible to satisfy during the tax year in question since that was the year in which the sale and exchange occurred.
Remember, the constructive receipt problem can be avoided by using the safe harbor provisions of the deferred exchange regulation. Not to use them is an unnecessary and foolish risk.
There are four safe-harbors you may use to avoid constructive receipt. Reg. 1.1031(k)-1 explains the IRS rules for application of §1031 and related regulations for deferred exchanges. Included are rules for Time Restrictions and the use of safe harbors to avoid constructive receipt.
It’s OK for your transferee to be your agent, but only if the transferee is a Qualified Intermediary. A Qualified Intermediary is a person (or company) who, for a fee, acts to facilitate the deferred exchange by entering into an agreement with you for the exchange of properties.
To clarify what an intermediary must do to acquire property, the regulations describe limited circumstances under which an intermediary is treated as acquiring and transferring property regardless of whether, under general tax principles, the intermediary actually acquires and transfers the property.
An intermediary is treated as acquiring and transferring property if
The intermediary acquires and transfers legal title to that property.
The intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than the exchanger for the transfer of the Relinquished Property to that person. Under the agreement, the intermediary transfers the Relinquished Property to that person.
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 Replacement Property for the transfer of that property. Under the agreement, the intermediary transfers the Replacement Property to the exchanger. Solely for these purposes, the intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property.
The exchanger or a disqualified person cannot qualify as qualified intermediaries for their own exchange. A person is a disqualified person if:
The person is an agent of the exchanger at the time of the transaction.
The person and the exchanger bear a relationship described in Section 267(b) or Section 707(b). However, you must substitute “10 percent” for “50 percent” each time it appears in those Sections.
The person and a person who is an agent of the Exchanger at the time of the transaction bear a relationship described in (2) above.
These people are treated as agents of the exchanger: A person who has acted as the exchanger’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties. However, the regulation disregards certain services for purposes of determining if an agency relationship exists. Performance of services with respect to exchanges of real estate intended to qualify under §1031 is not taken into account.
Furthermore, performance of routine financial, title insurance, escrow, trust services by a financial institution, title insurance company, or escrow company is not taken into account.
Here are some examples to illustrate the disqualified person definition. In all examples, Exchanger enters into an exchange agreement with Jones to retain Jones to facilitate an exchange of real property Happy Acres.
Jones is Exchanger’s accountant and has rendered accounting services other than with respect to §1031 exchanges of property to Exchanger within the 2-year period ending on May 17, 1991. Jones is a disqualified person. If Jones had not acted as Exchanger’s accountant within the 2-year period ending May 17, 1991 or if Jones had acted as Exchanger’s accountant within that period only with respect to Section 1031 exchanges, Jones would not be a disqualified person.
Jones is engaged in the business of acting as an intermediary to facilitate deferred exchanges. Jones is a wholly owned subsidiary of an escrow company that has performed routine escrow services for Exchanger in the past. Jones has previously been retained by Exchanger to act as an intermediary in prior §1031 exchanges. Jones is not a disqualified person notwithstanding the intermediary services previously provided by Jones to Exchanger and notwithstanding the combination of Jones’s relationship to the escrow company and the escrow services previously provided by the escrow company to Exchanger.
Jones, Inc. is a corporation only engaged in the business of acting as an intermediary to facilitate deferred exchanges. Each of 10 law firms own 10 percent of the outstanding stock of Jones, Inc. One of the 10 law firms that own 10 percent of Jones, Inc. is Mason and Mason. Eileen is the managing partner of Mason and Mason and is the president of Jones, Inc. Eileen, in her capacity as a partner in Mason and Mason, has also rendered legal advice to Exchanger within the 2-year period ending on May 17, 1991, on matters other than §1031 exchanges.
Eileen and Mason and Mason are disqualified persons. Jones, Inc., however, is not a disqualified person because neither Eileen or Mason and Mason own, directly or indirectly, more than 10 percent of the stock of Jones, Inc. Eileen’s participation in the management of Jones, Inc. does not make her a disqualified person.
Here’s a transaction where everything went wrong. It’s an excellent example of why an exchanger should retain the services of a good Qualified Intermediary and tax advisor before entering into a §1031 exchange. Especially one involving related taxpayers.
In FSA (Field Service Advice) 200048021, the IRS said a father who sold his property to his children couldn’t qualify for nonrecognition of gain under §1031(a) on the exchange of his property for an interest in another property.
Here’s what happened—the father wanted to sell his property to his four children. They drew up an exchange agreement for a like-kind exchange, but failed to identify the property being exchanged. The father then deeded the property to the children, and the children executed a promissory note designating their father as the lender and another individual as the escrow agent. The children did not own any replacement property, so the father located it for them. Only then did the father then contacted a Qualified Intermediary for the exchange.
In the meantime however, the father actually received the deed to the property directly from the owner. The children later sold small portions of the property they received from their father to unrelated third parties. The IRS said the father was not entitled to the benefits of §1031.
First, the escrow agent didn't satisfy the definition of a Qualified Intermediary. Second, the father failed to unambiguously identify the replacement property. Third, the father was in constructive receipt of the proceeds from the sale of his relinquished property before receiving his replacement property. This violated the constructive receipt rules since the father never did use the safe harbor rules available from a Qualified Intermediary.
The IRS said the father's transfer to his children did not even qualify as a §1031 exchange at all, even as an exchange between related persons because the father did not exchange property with his children, but rather sold property to them.
Up until 1990, when the IRS finally issued the long needed definitive guidelines, exchanging real estate was confusing and many times fatal. Thousands of deferred exchanges were disallowed when challenged by the IRS. The new regulation—1.1031(k)-1—changed all that. For the first time we had a bulletproof plan to follow in structuring “IRS safe” deferred real estate exchanges.
The biggest, most important change was the creation by IRS of the Qualified Intermediary function necessary to make deferred exchanges work within the restrictions and definitions of the Internal Revenue Code. That’s why the role of the Qualified Intermediary has become crucial to successful deferred §1031 exchanges.
The importance of this central position cannot be over emphasized—it is vital. An inexperienced or incompetent Qualified Intermediary can sink your exchange faster than the Titanic went down. You must choose a Qualified Intermediary that gives you fast, accurate and reliable service with an up front schedule of fees charged.
To help you choose your Qualified Intermediary, here are some guidelines and a checklist to guide you.
Track Record – How long has the company been in the qualified intermediary business? If they are in their tenth year or more, they have been there from the start. That’s good. You should insist they have the ability to exchange properties anywhere in the United States and the U.S. Virgin Islands. And national experience in making these exchanges is a must.
Real Estate Background – Exchanging is a series of real estate transactions subject to strict time limits and other requirements. Some transactions can get very sticky and mess you up. When this happens, you need the experience and know-how of a QI with a solid background in real estate brokerage to help guide and problem-solve you through. If your exchange gets in trouble, you want—no, you need—a QI who can jump in and help you. Not some inexperienced QI who has not been there and done that. You need a lot more than a QI with only financing or title business experience.
One easy way to check on real estate experience: Find out if the owners hold professional designations earned by study and experience through national real estate organizations. Examples are Accredited Land Consultant (ALC) awarded by the Realtors Land Institute, Graduate, Realtors Institute (GRI), and Certified Residential Specialist (CRS), awarded by the National Association of Realtors. It takes a lot of time and experience to earn these and other designations—the kind of experience you need in your QI.
Support and Help – How much support can you get when you need it? Can you deal directly with the Qualified Intermediary company owners, not hired staff, clerks, or branch offices? This assures you of quick, on the spot reliable answers when you need them. I learned of a case where a client called the local office of a large Qualified Intermediary company to set up an exchange transaction. It took almost a month to get all the details worked out to get the transaction in motion. Then one day, the client needed an answer on one of the issues and called the QI. The person answering the phone was not familiar with the transaction and the client spent considerable time bringing her up to date. The staff person at the QI told the client that the exchange as described could not qualify for §1031 treatment. By now the client is in orbit. It turns out the phone call to his QI was rolled over to another office in another city. So much for high tech.
Security – Insist on a complete up-front disclosure of how your funds are secured. Your sales proceeds can run into hundreds of thousands of dollars—your dollars—and its safety is critical.
Fees – Fees can be a real sticky wicket. It’s a must to get an honest disclosure of fees up front. No low-balling or hidden charges that pop up at the closing. Beware of QIs who quote a flat fee only to add on all kinds of extra charges at the closing. Insist on a fee schedule in writing before you commit.
References – Be sure to check out the Qualified Intermediary’s bank and attorney references. These two are a must. And look for other references such as memberships in professional organizations such as the National Association of Realtors® and the Federation of Exchange Accommodators.
A Word for Real Estate Agents – One of the most difficult areas of your real estate practice is the art of recommending other professionals to your clients. For example, you have listed a property for sale by your client seeking a §1031 deferred exchange. As part of this transaction, your client will need the services of other professionals such as a Qualified Intermediary, title companies, lenders, and the like. In your client counseling session, you should establish the identity of the client’s attorney, banker, etc. These people have a current relationship with the client and this relationship should never be endangered by you recommending or directing them to someone else. If the client has a genuine need for the services of another professional, your recommendation should be the very best you know of to serve your client’s transaction requirements, and not based on friendships or reciprocal agreements with others.
A Word for Principals Making the Exchange - The safe harbors of deferred exchanges specifically permit the Qualified Intermediary to be your agent, answerable only to you—absolutely no one else. Real or perceived. Be careful of “steering.” Steering is the act by real estate agents and others referring business to friends or related parties. In our opinion, your QI should have no relationship or business connections to other parties you are dealing with in your deferred exchange transaction.
It’s OK for the obligation requiring the transfer of Replacement Property to you to be secured or guaranteed by one or more of the following:
· a mortgage, deed of trust, or other security interest in property (other than cash or a cash equivalent),
· a standby letter of credit which does not allow you to draw on the standby letter of credit except upon a default of your transferee’s obligation to transfer like-kind Replacement Property to you, and
· a guarantee of a third party. The letter of credit must also satisfy all of the requirements of 15A.453-1(b)(3)(iii) dealing with installment sales. [xviii]
It’s OK for the obligation requiring the transfer of Replacement Property to you to be secured by cash or a cash equivalent if the cash or cash equivalent is held in a qualified escrow account or in a qualified trust.
A qualified escrow account is an escrow account where you are not the escrow holder or the escrow holder is not a related party. In addition, your rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account are limited.
You must not have the right to receive money or other property until
after you have successfully completed the exchange, or
you fail the identification or exchange period requirements.
If you do, you will lose your safe harbor protection to the extent you have the ability or unrestricted right to receive money or other property before you actually receive like-kind Replacement Property. This safe harbor applies only until you have such an ability or unrestricted right.
A qualified trust is a trust where you are not the trustee or the trustee is not a related party. In addition, your rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the trust account are limited the same as qualified escrow accounts.
Funds held in a qualified escrow account or qualified trust, or held by a qualified intermediary, may be needed to pay closing costs for the Exchanger. Even though the Exchanger will be in constructive receipt of funds used to pay these costs, the use of this money to pay certain specified items will not result in actual or constructive receipt of the remaining funds.
The certain specified items are transactional items that
· relate to the disposition of the Relinquished Property or to the acquisition of the Replacement Property, and
· are listed as the responsibility of a buyer or seller in the typical closing statement under local standards.
Examples of these transactional items include commissions, prorated taxes, recording or transfer taxes, and title company fees. In addition, an Exchanger’s rights to receive items (such as prorated rents) a seller may receive as a consequence of the disposition of property and are not included in the amount realized from the disposition of property are disregarded.
Under the regulations, the Exchanger may receive money or other property directly from another party to the transaction, but not from a qualified escrow account, a qualified trust, or a qualified intermediary, without affecting the application of a safe harbor.
Your Qualified Intermediary must manage the cash proceeds from the sale of your Relinquished Property following strict IRS rules and regulations. Here are some frequently asked questions reported by Jim Maxwell in his role as President of Realty Exchangers Incorporated.
Question – What should I do with the Earnest Money deposit on the sale of my Relinquished Property?
Answer - When selling relinquished property in a 1031 exchange, you must avoid actual or constructive receipt of the earnest money deposit. The earnest money should never be deposited in your own account. It should be deposited in an escrow account, or real estate brokers trust account, or with your QI. The earnest money receipt should state that the funds are to be assigned to the QI, and that you have no control or right to direct how these funds are to be used.
Question - How do I handle the earnest money deposit for the purchase of my Replacement Property?
Answer - The best and safest way is to make the deposit from your personal funds. Any unused funds brought into the replacement property transaction, other than the exchange proceeds being held by your QI can be reimbursed at the time of closing. Exchange proceeds can only be used for earnest money if the purchase and sale agreement has been assigned in writing to your QI And even then they are not true earnest money as the funds can only be released to the seller at the time of closing. If the transaction fails to close the funds will be returned to your QI.
Question - Do I have to spend all of the proceeds from my relinquished property on replacement property?
Answer - No you don’t. However, any amount you don’t spend will be treated as boot received and taken into account when figuring your net boot received.
Question - If I don’t spend all of my proceeds when can I receive the unused amount?
Answer - You can receive unused proceeds anytime after you have acquired all of the properties identified in your 45-day identification time period. If you do not acquire all of the properties identified in the 45-day identification, then the unused proceeds cannot be released until the earlier of the due date of your tax return including extensions, or 180 days after the closing of the sale of the Relinquished Property.
Question - If I decide not to go through with my exchange when can I get my money back?
Answer - We can return your proceeds at any time you decide to abandon your exchange, or in the event you are unable to find Replacement Property to identify by the end of the 45-day period. There is no charge for the return of proceeds.
Question - Many old timers in exchanging talk about the “napkin test.” I know it has something to do with the cash proceeds from sale of the Relinquished Property—if you don’t spend all the proceeds or more on the new property then you get taxed on the difference. Please explain.
Answer - The term “napkin test” was coined by one of the old time gurus in exchanging to describe the basic rule that all cash proceeds from the sale of the Relinquished Property must be “reinvested” in the Replacement Property to avoid recognized taxable gain from the exchange. If you trade up, and all the cash is “reinvested”, no taxable boot. But if you trade down, and all the cash is not “reinvested”, the net cash back to you is treated as cash boot received and recognized as taxable gain.
However, there is an adjustment to cash boot received not realized by many when the exchange is originated and in the planning stages. Selling expenses paid in connection with a §1031 exchange are treated as cash boot paid and offsets any boot received. Selling expenses include brokerage commissions and other closing costs such as title policy fees, escrow fees, and recording fees. This means you can trade down by the amount of your selling expenses paid and still have no recognized gain. Here is an example of this vital tax-planning tool.
You sell your Relinquished Property and the cash proceeds total $135,000. Your selling expenses total $32,000 of which you paid $10,000 outside of escrow. The balance of the selling expenses or $22,000 was paid through escrow and the net proceeds of $113,000 are paid into your QI’s trust account. At this point, your net cash boot received is $103,000 and this is the amount you need to “reinvest” to avoid net boot received and taxable income.
Caution: Selling Expenses are all expenses directly related to the sale of the Relinquished Property and is the amount used by IRS to deduct from the Selling Price to figure the Adjusted Sales Price. Selling expenses do not include interest, points, taxes, fixing up expenses, repairs, insurance, operating expenses of the property, personal bills or impound account adjustments. Occasionally selling expenses are paid outside of escrow. For example, a consulting fee paid in connection with the transaction may qualify as a selling expense. Be sure to check with your tax professional if you have any questions regarding your particular selling expenses. See Chapter Four for more discussion of this important topic.
It’s OK to earn interest on money being held in the deferred exchange. You are treated as being entitled to receive interest or a growth factor if the amount of money or property you are entitled to receive depends upon the length of time elapsed between transfer of the Relinquished Property and receipt of the Replacement Property.
If you receive interest or a growth factor, the interest or growth factor will be treated as interest, regardless of whether it is paid to you in cash or in property (including property of like-kind). You must report the interest or growth factor in your income according to your method of accounting.
There’s an interesting aside regarding the use of the term “growth factor” that I believe to be one of the ultimate tax puns. In the famous Starker case there was a separate issue related to the 6% to be added to the unpaid exchange price to Starker. Under the Land Exchange Agreement, this 6% amount accrued over the two years it took to close the account. IRS said it was interest and taxed as ordinary income. Starker argued it was a “growth factor” because the timberland Starker transferred had growing timber on it and the timber would be “worth more” after two years. Therefore, Starker claimed, it should be treated as like-kind property and qualify for §1031 treatment.
The court answered with a big, resounding NO! We can’t help chuckling over the fact that Starker claimed the annual timber growth rate just happened to be the same as the interest rate in effect at that time.
Under the deferred exchange regulations, direct transfer of the Relinquished Property and the Replacement Property is permitted.
On May 1, 1991, Exchanger enters into an agreement to sell White Acre to Davis for $100,000. However, Davis is unwilling to participate in a like-kind exchange. Exchanger enters into an exchange agreement with Arnold whereby Exchanger retains Arnold to facilitate an exchange of White Acre. Arnold is not a disqualified person. In the exchange agreement between Exchanger and Arnold, Exchanger assigns to Arnold all of Exchanger’s rights in his agreement with Davis.
The exchange agreement expressly limits Exchanger’s rights to receive, pledge, borrow, or otherwise obtain benefits of money or other property held by Arnold.
On May 17, 1991, Exchanger notifies Davis in writing of the assignment and executes and delivers to Davis a deed conveying White Acre to Davis. Davis pays $10,000 to Exchanger and $90,000 to Arnold. On June 1, 1991, Exchanger identifies Black Acre as Replacement Property.
On July 5, 1991, Exchanger enters into an agreement to purchase Black Acre from Williams for $90,000, assigns his rights in that agreement to Arnold, and notifies Williams in writing of the assignment. On August 9, 1991, Arnold pays $90,000 to Williams and Williams executes and delivers to Exchanger a deed conveying Black Acre to Exchanger.
Because Exchanger’s rights in his agreements with Davis and Williams were assigned to Arnold, and Davis and Williams were notified in writing of the assignment on or before the transfer of White Acre and Black Acre, Arnold (the Qualified Intermediary) is treated as entering into those agreements. Arnold is treated as acquiring and transferring White Acre. Similarly, Arnold is treated as acquiring and transferring Black Acre.
Because Exchanger did not have the immediate ability or unrestricted right to receive money or other property held by Arnold before Exchanger received Black Acre, he is not in actual or constructive receipt of the $90,000 held by Arnold before receipt of Black Acre. The transfer of White Acre by Exchanger and Exchanger’s acquisition of Black Acre qualify as an exchange under §1031.
For purposes of deferred exchange rules only, a person is a related party to you if:
· Such person and you bear a relationship described in either section 267(b) or section 707(b) determined by substituting “10 percent” for “50 percent” each place it appears.
· Such person acts as your agent (including for example, by performing services as the taxpayer’s employee, attorney, or broker), or
· Such person and a person described in (2) above bear a relationship described in (1) above.
In determining whether a person acts as your agent, solely for purposes of this paragraph, the following are not taken into account:
· The performance of services for you with respect to exchanges for property intended to qualify for nonrecognition of gain or loss under Section §1031, and
the performance by a financial institution of routine financial services for you.