When a taxpayer sells real or personal property held in a business, trade or for investment and a gain is realized on the sale, the taxpayer typically incurs a capital gains tax obligation on the sale. One way a taxpayer can defer the payment of capital gains taxes is to enter into a Section 1031 Exchange instead of a traditional sale. As the name implies, the concept behind a 1031 Exchange is that the taxpayer relinquishes one property and replaces it with another one of “like-kind”. There are a number of other guidelines that must be followed for a transaction to qualify for Section 1031 Exchange treatment including the requirement that the entire transaction be completed within 180 days and that a Qualified Intermediary, or QI, be used to facilitate the exchange. One responsibility of the QI is to hold onto any funds used or acquired during the exchange. Upon occasion a taxpayer may wish the return of his or her funds prior to the expiration of the 180 day exchange period; however, a QI cannot simply return funds upon the request of the taxpayer. In fact, a QI may only return funds under specific circumstances according to the Section 1031 Exchange rules.
Qualified Intermediary Requirement
What happens, for example, if a taxpayer enters into a Section 1031 Exchange agreement and then changes his/her mind? Often, when this occurs the taxpayer contacts the QI and asks for the return of funds, fully expecting the QI to accommodate the request. Unfortunately, a QI is bound by the rules of Section 1031 and may not be able to return the funds immediately. Specifically, the QI must keep in mind the “Safe Harbor” rules found in Section 1031. The Safe Harbor rules are intended to make sure that a taxpayer is never in actual or constructive receipt of money or other property during the transaction which, in turn, ensures that the transaction will qualify as an exchange instead of a traditional sale. For a transaction to qualify it is crucial that the QI maintain his or her objective position within the transaction and not be viewed as an agent of the taxpayer. Therefore, Section 1.1031(k)-1(g)(6) sets forth the conditions under which a taxpayer may request a return of funds or property from the QI:
- After the 45th day expires if the taxpayer has failed to identify any replacement property OR
- The receipt by the taxpayer of all of the replacement property to which the taxpayer is entitled under the exchange agreement OR
- After the expiration of the 180 day exchange period OR
- The occurrence after the end of the identification period of a material and substantial contingency that—
(1) Relates to the deferred exchange,
(2) Is provided for in writing, and
(3) Is beyond the control of the taxpayer and of any disqualified person (as defined in paragraph (k) of this section), other than the person obligated to transfer the replacement property to the taxpayer.
Private Letter Ruling
While the first three conditions are relatively clear, the last leaves room for interpretation. To date, the IRS has taken a very narrow view in its interpretation. In Private Letter Ruling 200027028, for example, a QI requested a ruling on a proposed change to their standard QI agreement with regard to circumstances under which amounts held by the QI could be made available to the taxpayer prior to the expiration of the exchange period. The proposed change read as follows:
“owner, after negotiating in good faith with the seller (or sellers) of all identified Replacement Properties which have not yet been acquired, is unable to conclude a binding agreement (or agreements) for the purchase of all of such properties, but in such case, only at the time all Replacement Properties for which binding agreements (or agreement) have been concluded have been acquired.”
The proposed addition was intended to cover situations where a taxpayer has negotiated in good faith but has been unable to conclude an agreement and then contacts the QI asking for a return of funds. The IRS did not allow the proposed language stating that:
“The amendment is too broad to qualify under subdivision (B). In essence, the amendment would apply to any case where the owner, after bargaining in good faith, could not acquire one or more of the identified replacement properties.”
It appears, based on examples cited in the PLR, that the IRS interprets the “beyond the control of the taxpayer” to refer to an act of a third party such as a government seizure of the property or an act of nature such as destruction of the property.
Outcome
Therefore, a taxpayer must understand that once a Section 1031 Exchange agreement has been entered into a QI is not allowed to return funds prior to the expiration of the exchange period except under very limited circumstances.
To receive a 10 point 1031 Checklist when considering a 1031 exchange, click here.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
