RECEIPT OF PROCEEDS FROM THE SALE OF RELINQUISHED PROPERTY  

Role of the Qualified Intermediary

The IRS does not permit tax-deferral to a taxpayer who receives, directly or indirectly, the cash proceeds from the sale of relinquished property, and later purchases designated property, trying to claim an exchange after the fact.  The need to avoid constructive receipt of the proceeds led to the creation of the qualified intermediary and similar safe harbors described in the Regulations.  Although it is not possible to predict all situations that taxing authorities will consider actual or constructive receipt of proceeds, exchanges structured correctly with a qualified intermediary have proven successful in avoiding any question of constructive receipt. 

Most exchanges begin with the payment of net closing proceeds on the relinquished property being made directly to a qualified intermediary by the closing agent.  This direct payment avoids most issues of constructive receipt so long as the QI has a written exchange agreement in place as required by Regulation Section 1.1031(k)-1(g)(6).

Because Section 1031 is not an “all or nothing” statute, a taxpayer may choose to receive cash or debt relief boot in an exchange.  The amount of cash or other property paid over at closing to the taxpayer is boot and is not included in the exchange value requirement. All such boot will be subject to capital gains tax as of the date of sale. If a taxpayer desires to intentionally take cash boot at the closing, it must be done at closing on the relinquished property because of the restrictions placed on the funds once they are held by the Qualified Intermediary. Additionally, a taxpayer may choose to purchase property with all of the cash proceeds through a QI, but not to replace debt relieved in the sale of the relinquished property.  Such debt relief in also boot and will be taxable as of the date of the sale of the relinquished property.

Release of Exchange Proceeds

Once a taxpayer has begun an exchange with a QI, the circumstances under which the exchange proceeds or remainder thereof may be released to the taxpayer are rather firm. A QI and taxpayer must enter into an agreement governing the exchange, and that agreement must limit access to the funds to prevent a determination that the taxpayer had constructive receipt.  The following list outlines the accepted conditions under which a taxpayer may receive the proceeds from an exchange:

            1.         If the taxpayer fails to identify replacement property within the identification period, or if the taxpayer identifies replacement property in such a way as to disqualify the identification as defined within IRC §1031, the exchange will terminate, and the qualified intermediary may pay the exchange proceeds to the taxpayer after the end of the identification period, so long as no replacement property has been identified by way of purchase as of that date.

            2.         If the taxpayer has timely identified replacement property, then funds may be released after the taxpayer has received all of the identified replacement property to which the taxpayer is entitled.  One caveat with this section is that, if the taxpayer does not purchase all the replacement properties identified, then the exchange proceeds cannot be released until after the exchange period.  This is due to the IRS’ position that, if there are properties left on the taxpayer’s identification that were not purchased, they are still considered to be properties “to which the taxpayer is entitled”, and thus the exchange will not be complete until the tolling of the 180th day.

            3.         If the taxpayer has timely identified replacement property, then after the expiration of the identification period and prior to the expiration of the Exchange Period, funds may be released subsequent to the occurrence of a material and substantial contingency that: (i) relates to the deferred exchange; (ii) is provided for in writing; and (iii) is beyond the control of the taxpayer and of any disqualified person as defined in Treasury Regulation §1.1031(k)-1(k).  However, a decision by the taxpayer not to complete the exchange or not to purchase all property identified does not entitle the taxpayer to terminate the exchange and receive the exchange proceeds prior to the expiration of the 180-day exchange period.

            4.         Otherwise, at the end of the exchange period.  The proceeds from the sale should be placed directly into the account maintained by a QI.  The exchange agreement should provide protection for the taxpayer from unlawful use and disbursement of the proceeds, as well as compliance with restricting the taxpayer’s use or access to the funds under §1.1031k-1(g)(6).