Constructive Receipt Issues
A taxpayer cannot take actual possession or be in control of the net proceeds from the sale of relinquished property in a 1031 exchange. For tax purposes, the taxpayer does not receive payment, rather those funds are being held for application towards a replacement property to complete the exchange. Should no replacement property work out by the end of the 180-day exchange period or no property be identified by the end of the 45-day identification period, the funds can be received, and the sale would be reported as such. However, the following pitfalls must be avoided by the taxpayer and the exchange company.
1031 Exchange Pitfall No. 1 – Receipt of Excess Funds
Often, a taxpayer will identify more than one possible replacement property but acquire just one during the exchange. Generally, when an exchange is completed, it is permissible to return excess funds. However, if the taxpayer has identified more than one property and there are still available funds in the account, the taxpayer, whether or not he had the intention to, could use those funds to buy another property. In such a case, the funds need to be held until a termination event occurs (usually 180 days from the inception of the account).
Should the excess proceeds be returned earlier and the taxpayer found to have some control of the funds, the exchange could be jeopardized. An exchange company can prevent this situation in advance by requiring the taxpayer to indicate how many of the designated properties he intends to acquire.
For example, if two properties are identified as potential replacement properties, and the taxpayer indicates that they are in alternative to one another (only one is intended to be purchased), most exchange companies will release excess funds after one is purchased, since the clear intent was for the second property to be a backup if the first one could not be acquired.
1031 Exchange Pitfall No. 2 – Payment of Certain Transactional Costs
The Regulations permit the payment of certain transactional costs out of the exchange account. In order for the costs to be eligible, they have to (i) pertain to the disposition of the relinquished property or the acquisition of the replacement property and (ii) appear under local standards in a typical closing statement as the responsibility of the buyer or seller. The first criterion is almost always present; it is the second that can be problematic.
As an example, payments relating to a loan on the replacement property, such as a loan application fee, points, credit report, etc., are not an exchange expense, rather they are capitalized into the cost of the replacement property. However, expenses for real estate commissions, transfer taxes, recording fees and other expenses would seem to fall within the requirements of the second criterion and are properly paid out of exchange expenses.
Exchange companies are sometimes asked to pay for legal fees or accountant fees out of the exchange account. Often, the attorney fees or accounting fees pertain exclusively to the exchange transaction. In these instances, the attorney can be asked to provide a memo or e-mail confirming his opinion that the attorney fee appears under local transactions in a typical closing statement as the responsibility of the buyer or seller. Fees for accountants, for example, do not usually appear on closing statements anywhere, and the exchange company would be well advised to withhold this kind of payment request.
Once, again, the larger point here is that allowing access to the exchange funds for costs or expenses that are not permitted would put the taxpayer in constructive receipt of the funds.
1031 Exchange Pitfall No. 3 – Earnest Money Payouts
It is not unusual for a taxpayer to provide earnest money at the time the replacement property contract is entered into. At some time prior to the closing of the replacement property purchase, the taxpayer will request a reimbursement for the advance of funds used to purchase the property. Unfortunately, under the exchange rules, a taxpayer cannot receive a benefit (much less a payment) from the exchange account.
As an alternative, the taxpayer may request that the exchange company make a superseding earnest money payment and arrange for the person holding the original deposit to return it directly to the taxpayer. Another alternative would be to ask the closing agent to show an offsetting debit line item on the settlement titled “Reimbursement of prepaid earnest money to buyer.” The exchange company can overfund the wire to closing by the amount of reimbursement, and the taxpayer can be reimbursed by the closer in the closing.
A related issue occurs if the exchange company has not yet been assigned the taxpayer’s rights under the new purchase agreement when an earnest money deposit is requested. When the taxpayer enters into the replacement property contract, it is he who is contractually obligated to furnish the earnest money. If the taxpayer requests earnest money to be paid out of the exchange account, he is obtaining the benefits of the exchange funds. A better practice is to assign the contract rights to the exchange company at the same time the earnest money is requested. Once that assignment is made, the exchange company is linked into the purchase agreement and has a basis to make the requested payment upon the client’s request.
1031 Exchange Pitfall No. 4 – Early Return of Funds
At various times during the exchange period, a taxpayer may elect not to proceed with the transaction. When this happens, the taxpayer will tell the exchange company that he understands that he will pay applicable taxes on the gain. Under the regulations, exchange facilitators are only permitted to disburse funds at specific times for specific reasons. The election by the taxpayer to terminate the account is not one of those instances.
In such a case, the client may not care if the rules are not followed – after all, he is agreeing to pay the applicable taxes. The problem is that if the exchange facilitator is found to be deviating from the rules, previous exchanges for this taxpayer as well exchanges for other taxpayers serviced by the exchange company could be jeopardized.
1031 Exchange Pitfall No. 5 – To Whom was the Property Identified
The exchange company must be careful not to allow the return of funds other than in a prescribed manner. Generally, one of the permitted factors that allows for the return of the funds is the failure by the taxpayer to identify any property within the 45-day designation period. Although the designation notice is customarily given to the exchange company, the regulations provide that the designation can be valid so long as it is in writing and is given to “any party” to the transaction.
For example, the taxpayer may provide within the replacement property purchase agreement that the subject property is being identified as the taxpayer’s replacement property in an exchange. So in addition to confirming that the exchange company received no designation, the taxpayer should confirm that the designation was not given to any other party to the transaction. Otherwise, the taxpayer could be receiving funds after the identification process but before the termination of the transaction. Once again, the payment of the funds in this scenario could be viewed by the IRS as a departure from the rules.
1031 Exchange Pitfall No. 6 – Attorney as Settlement Agent
In some jurisdictions, closings are facilitated by a title insurance company. In others, the taxpayer’s attorney will act as closing agent. In this capacity, the attorney will be in possession of the exchange funds in order to make disbursements as needed from the closing. The regulations state in part that, “In addition, actual or constructive receipt of money or property by an agent of the taxpayer…is actual or constructive receipt by the taxpayer.” Attorneys will frequently state that there is a distinction between their representation of a client and their actions as the closing agent for the parties. In non-exchange transactions, it wouldn’t matter that the attorney is acting in both roles.
The treasury regulations speak to who can and cannot act as a qualified intermediary (the exchange facilitator). In general, those persons who are agents of the taxpayer cannot do so; the regulations refer to those prohibited persons as a “disqualified person[s].”
“DEFINITION OF DISQUALIFIED PERSON. (1) For purposes of this section, a disqualified person is a person described in paragraph (k)(2), (k)(3), or (k)(4) of this section. (2) The person is the agent of the taxpayer at the time of the transaction. For this purpose, a person who has acted as the taxpayer’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 is treated as an agent of the taxpayer at the time of the transaction.”
The definition of the attorney as an agent in the above rules makes clear that, if the attorney has provided legal services within the two years preceding the exchange, the attorney is a disqualified party. It is fair to say that if the attorney is a disqualified person as a result of being the taxpayer’s agent, then it is not a stretch to consider the attorney who holds taxpayer funds to place the taxpayer in constructive receipt.
There are many ways an exchanger can get tripped up even if he is acting in good faith to keep to the regulations, particularly when it comes to constructive receipt of the funds. And sometimes the activities that can lead to an allegation of constructive receipt are less than obvious. The taxpayer or taxpayer’s counsel should take great care to avoid these possible pitfalls. Learn about more pitfalls to avoid in 1031 Like-Kind Exchange Pitfalls to Avoid – Part II.
on Thu, 04/28/2016 – 08:50 Martin Edwards
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031 Exchange Pitfall No. 7 – Execution of the Exchange Agreement and Identification Forms
Often relinquished property in a tax deferred exchange can be held by co-owners, including spouses. This is documented differently than an LLC where the spouses are sole members. In the event of co-ownership, either spouse can make decisions on behalf of the couple and even sign the other spouse’s name. In other co-ownership arrangements, one co-owner may sign for the group of co-owners. However in an exchange transaction, it is important to stick to the formalities of each person with an ownership signing all applicable documentation. Failure to do so will invalidate the exchange.
1031 Exchange Pitfall No. 8 – Identification of a Group of Replacement Properties
Most replacement properties are identified according to the three property rule, meaning that a taxpayer may identify up to three replacement properties, regardless of their value. It doesn’t matter how many of the three properties are purchased, however problems arise when one party doing an exchange wishes to acquire a group of properties that are owned by one seller and sold under one contract. While there is a temptation to consider the group as one property, there does not appear to be any foundation for identifying them as one property.
A similar issue arises when a taxpayer wishes to identify a small percentage in a group of properties in which that interest is being sold as a Delaware Statutory Trust (DST). These are popular with taxpayers who want a good-yielding, secure investment that involves no management headaches. However, the number of different properties underlying the individual investment are considered separate properties for exchange purposes. The 200% rule may be helpful in these instances.
1031 Exchange Pitfall No. 9 – Diminution of Exchange Proceeds Due to Prorations
In the case of a non-exchange sale of property, it is customary to give the buyer a credit for partial month’s rent held by the taxpayer as well as the security deposits. Most practitioners prepare an exchange-related closing statement the same way. While it makes no difference if the transaction is not part of an exchange, it does make a difference when an exchange is taking place. More specifically, the taxpayer is retaining the value of the rent and security deposits and thereby reducing the cash received for the exchange account. In other words, a taxpayer cannot retain these items of income and offset the amount of money going into the replacement property. The best solution is to pay to the buyer directly for the rent and security deposits and not give a credit on the closing statement.
1031 Exchange Pitfall No. 10 – Notice to All Parties to the Agreements
In a 1031 exchange, the taxpayer assigns his rights for both the sale of the old property and purchase of the new property to the qualified intermediary. Under safe harbor exchange procedures, the taxpayer must give notice in writing to all parties to each contract of the assignment of rights to the qualified intermediary. In most cases when a taxpayer is dealing with one buyer and one seller, this notification is easily done. However sometimes there are many buying or selling entities as well as third parties. I recently reviewed a contract in which the title insurance company was included as a party under the contract. Care must be taken to ensure that all parties receive such notice, not just the counterparty. Note, however, that although it is customary to request the counterparty’s signature on this notice of assignment in order to prove compliance should the transaction be audited, the counter-signature is not a requirement.
Misconceptions About Exchanges
Often, when real estate investors hear about the benefits of a 1031 Exchange for the first time, they ask the question “If this process is so beneficial, then why doesn’t everyone do it?” The simple answer is that many people have misconceptions – a lack of understanding and a lack of planning. This article will explore and dispel some of the more common misconceptions about 1031 Exchanges for those who are unfamiliar with the process.
Misconception 1 – I need to do an actual “swap” – property for property with another person interested in exchanging
While this is how Exchanges were once structured, Exchangers are now free to sell their property to anyone they wish, and to buy from anyone they wish. Although there are a few issues regarding sales and purchases between related parties, most Exchanges are structured not unlike any other typical sale and subsequent purchase; the benefit is the capital gains tax deferral which provides investors with additional purchasing power. A 1031 Exchange does not obviate the need for a realtor. Quite to the contrary, in most cases an Exchanger has an even greater need for a realtor due to the time constraints placed on Exchangers. Simply put, an Exchange is a sale, just like any other sale, and a purchase just like any other purchase, but with some additional rules, time deadlines, and the involvement of a Qualified Intermediary.
Misconception 2 – The “swap” must occur in one simultaneous transaction
By virtue of a favorable court ruling for the taxpayer in the now famous case of Starker v. United States in 1979, and a subsequent re-write of I.R.C. Section 1031, Exchangers can complete an Exchange on a delayed basis so long as they purchase replacement property within 180 days of selling their first relinquished property. Other structures, including reverse exchanges and improvement exchanges, afford the Exchanger even more flexibility to utilize the exchange process.
Misconception 3 – An Exchanger must buy the exact type of property that they are selling
One of the greatest misconceptions of 1031 Exchanges involves the requirement that the real estate exchanged must be “like kind” to what is purchased. Many people wrongly assume that “like kind” means the same type of real estate (i.e. – apartment building exchanged for an apartment building or that the number of units or the size of the building matters). However, if the real estate to be sold, and the real estate to be purchased are held for the productive use in a trade or business, or for investment purposes, Exchangers are free to purchase whatever type of real estate they want. The use/intent of the Exchanger is what really matters and not the type of property. If an ownership interest is considered real property per the laws of the state in which the property is located, the interest will most likely qualify as a valid replacement property. In addition to exchanges of traditional interests in real property, exchanges of development rights, air-rights, timber rights, and mineral rights are not uncommon, depending on state law.
Misconception 4 – Residential property will not qualify as replacement property in a 1031 Exchange
Under the rules discussed above, residential property can be considered “like-kind” if it is held for investment purposes. The property type, zoning, and whether the real estate is improved or unimproved are not factors in determining whether property will qualify for an Exchange (i.e. vacant land can be exchanged for an apartment building, or even a shopping center or a factory). Residential property that is part of an exchange can even be rented to a relative, if properly documented, and leased at fair market value. However, a residential property for which the taxpayer’s primary intent for ownership is personal use, will not qualify as exchange property. For instance a taxpayer’s primary residence will not qualify and likewise, a vacation home that does not meet the IRS’s safe harbors may face scrutiny. In addition, real estate held primarily for re-sale or as inventory will not qualify (where a taxpayer has manifested an intent to sell the real estate at a gain, rather than hold it as an income property). All of these situations can be remedied by converting the disallowed use into a use which complies with the requirement of holding the property for business or investment purposes.
Misconception 5 – the legitimacy of the process: “1031 Exchanges are a tax loophole”
The above statement is incorrect. Exchanges are written into the U.S. Tax Code and have been available to taxpayers in one form or another for almost 100 years. Exchanges have been available in their current structures since 1986 and aren’t a loophole or some “tax magic.” Exchanges are allowed as part of the rules! Below is a famous quote explaining why there is nothing wrong with tax planning if one follows the rules:
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. … Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
— Judge Learned Hand, Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465 (1935).
Misconception 6 – I will be penalized if I start an exchange, but do not complete it.
There is no tax penalty for starting an exchange and cancelling it or failing to complete the exchange. The taxpayer would simply report any capital gains from the sale of relinquished property on their tax return for the year in which they received the exchange funds. If a taxpayer starts an exchange in one tax year, however, does not complete the exchange and receives sales proceeds in the next tax year, those proceeds are deemed taxable and may be reported in the year they are received. An exchange which is not completed can still sometimes benefit the taxpayer by pushing the gain into the next tax year under this scenario.
Misconception 7 – Exchangers must use all the proceeds from the sale of relinquished property to purchase replacement property and cannot use proceeds for other purposes.
Exchanges are not all or nothing, thus a partial tax deferral is possible. If an Exchanger buys a replacement property of equal or greater value as to the value of the relinquished property, uses all of the equity realized from the sale to purchase the replacement property, and obtains equal or greater financing on the replacement property as was in place on the relinquished property, the Exchanger will have a fully tax deferred exchange. In general, an Exchanger who wishes to buy a replacement property of a lesser value, or with less financing, or who wishes to use a portion of the proceeds from the sale of the relinquished property for something other than purchasing replacement property, will recognize a capital gains tax on only that portion of the funds which were not used for purchasing replacement real property. However, an exchanger subject to “debt boot” tax liability because they exchanged into a property with less financing, can use cash to offset the difference in financing and avoid recognition of a capital gain.
Misconception 8 – An Exchange must be one property for one property
There are no statutory limits to how many properties can be involved in an exchange. Some common motivating factors for multiple property exchanges include consolidating multiple properties into one replacement property or diversifying by using the equity in one property to purchase multiple replacement properties. In addition, it is common for an exchanger to purchase a fractional real estate interest like a tenant-in-common interest or an interest in a Delaware Statutory Trust when they have purchased a primary investment but have leftover exchange funds that are not enough to buy a net lease investment. There are considerations that do sometimes work to limit the number of properties which can be bought and sold, including the requirements of the 1031 exchange identification rules, as well as market forces dictating how quickly transactions can be completed with the 180-day time period.
Misconception 9 – I don’t need a Qualified Intermediary, I can simply have my attorney or accountant hold the sale proceeds until the replacement property is purchased.
A Qualified Intermediary is essential to completing a valid delayed Exchange. Basically, the IRS has disqualified from acting as an intermediary most any person or entity who you would normally trust with your Exchange funds. Some examples of disqualified parties are related persons and entities, any person or firm that has acted as an employee, real estate broker, attorney, accountant, agent or investment banker or broker within two years preceding the date of transfer of the relinquished property. If the Exchanger or any one of the disqualified parties comes into receipt of Exchange funds it would void the Exchange. Using a well-established Qualified Intermediary allows an Exchanger to take advantage of the “Safe Harbors” provided for in the Treasury Regulations and protects the Exchanger against “constructive receipt” of the Exchange funds. It is also a good practice to research the nature of the guaranties offered by the Qualified Intermediary.
Misconception 10 – Timing – I shouldn’t start considering the exchange until my relinquished property closes or is near closing.
A common mistake in the real estate industry is to wait until there is a sale contract in place for the relinquished property before discussing what to do with the proceeds from the sale. This misconception often leaves Exchangers with too little time to adequately prepare for an exchange and find a replacement property. The earlier an Exchanger considers options and discusses an exchange with their advisors, the smoother the exchange transaction will go. If the relinquished (sale) property is held in a business with a partner, both partners should discuss the exchange with their tax advisor, prior to the exchange process, ideally before listing the relinquished property for sale. In addition, Exchangers can begin looking at or conducting due diligence on replacement property early in the process of selling relinquished property. Doing so helps set expectations regarding the market and timing for potential replacement properties and gives the Exchanger extra time to prepare for the exchange and to evaluate potential replacement properties, versus waiting until the relinquished property is under contract.
In conclusion: These common misconceptions often prevent taxpayers from taking advantage of one of the best real estate tax strategies provided by the U.S. Tax Code. A 1031 exchange is much broader and inclusive than many investors initially believe and thus there are many more situations in which it is applicable. If you plan on selling real estate used in a trade or business or held for investment purposes, you should consult with your tax and legal advisors early in the sales process in order to properly plan, maximize tax benefits, and to make informed decisions on the exchange process.