We’ve written extensively on how you can take advantage of the Internal Revenue Code’s Section 1031 to defer tax liability on relinquishing property. We’ve also noted that the time period in which you can find a like-kind asset, and then buy it, is strict. If you miss the 45-day deadline (in which to identify a replacement asset) and the 180-day window (during which you must close on that replacement asset), the exchange might no longer be valid, and you end up owing taxes.
Another strict rule is that you, the relinquisher, are not allowed to control any of the exchange funds either directly or indirectly, during the process. Doing so puts you in constructive receipt of the money. That, in turn, can render your exchange null and void.
The Internal Revenue Service defines constructive receipt as funds that are “credited to the taxpayer’s account, set apart for him, or otherwise made available so that he may draw upon it at any time . . .” The rule of thumb is not to touch any of that exchange money. Even if those funds are just sitting in your checking account and you have no plans to withdraw them, you are considered in control of the funds. This is why a qualified intermediary (QI) is required to handle the entire exchange process.
There are many ways, during the exchange process, when constructive receipt could potentially be a potential problem.
Excess Funds. The goal of an exchange is to find a replacement product of equal or greater value than the property you are relinquishing. But you sometimes might not be able to – or even want to – invest the proceeds into the replacement. It’s perfectly okay to keep some of those proceeds through what is known as a partial exchange. But be sure your QI keeps those proceeds until the close of the 180-day period. At that point, the QI will release the remaining funds – known as “boot” – to you, and you’ll likely pay capital gains tax on those proceeds.
“But, wait a minute (you might be thinking). What about the discussion above, when it was made clear that those funds should in no way be in my bank account or possession?” The answer is: Timing. When you receive the boot from your QI, the exchange will be complete. That boot is the taxable portion of your exchange, rather than actual exchange funds. The message? Don’t ask your QI for the funds before the 180 days are up.
Transactional Costs. The good news is you (or rather, your QI) can pay some transactional costs, such as commissions, transfer taxes, and recording fees, out of the exchange account. The bad news is that other costs, which might include loan application fees, points, and fees for credit reports, cannot be paid with the exchange money. Using the funds for such expenses could put you in ownership of them, at least, in the eyes of the IRS.
Earnest Money. Earnest money is a great way to show good faith to a seller. And, you might think that, as earnest money is being used to acquire the replacement property, you could be reimbursed from the exchange account. But, you can’t just withdraw funds; the exchange account is not an ATM. This type of reimbursement could constitute receipt of a payment, or benefit – and constructive receipt. In order to properly handle this common issue, it is generally advised that the QI transfer the earnest money directly to the seller or closing agent. Another option is that the Exchanger makes the earnest money deposit with their own (non-1031) funds and that deposit is subsequently reimbursed with the exchanger’s 1031 proceeds from the QI at closing of said property.
Attorneys and Agents. Your attorney might be a trusted advisor, who assisted you on real estate closings in the past. However, as your agent, that attorney is an extension of yourself. In the eyes of the IRS, anyone who has had an agency relationship with you within the past two years cannot act as your QI. This is why, in a 1031 exchange, using your attorney as a QI is a bad idea. The IRS might examine this relationship and determine that you – through your attorney - are in constructive receipt of the exchange funds. This could negate any tax deferral.
An understanding of constructive receipt is important when it comes to 1031 exchanges. Care should be taken to ensure that only the QI has control of exchange funds. Failure to do so could jeopardize the exchange, and saddle you with a tax liability. For a more in-depth look at QI selection, see our Simple Guide to Choosing a 1031 Qualified Intermediary.Realized 1031 has decades of experience in overseeing successful 1031 exchanges. For more information about how Realized 1031 can help smooth your way to a complete exchange, log onto www.realized1031.com or call 877-797-1031.
1031 Exchange Guidebook
The 1031 Investor's Guidebook