Restrictions to Exchange Funds during a 1031 Exchange
One of the main rules for taxpayers in a 1031 Exchange is avoiding any “constructive receipt” issues. Constructive receipt occurs when the taxpayer “receives” sales proceeds when their real estate transaction closes, or if they have received the right to receive the funds at the closing. An example of this could be when the taxpayer’s transaction closes, but the funds are received by a third party (not a Qualified Intermediary) on behalf of the taxpayer, or if the sale closes and funds remain with the closing agent. In either case, the taxpayer has a right to the funds, making those funds taxable.
The 1031 regulations establish rules for avoiding this “constructive receipt” by creating a safe harbor when using a Qualified Intermediary (QI) to hold the sales proceeds. The regulations require that the taxpayer and the QI enter into an exchange agreement that limits the taxpayer’s access to the proceeds during the exchange period. The regulations define those limits in Sec. 1.1031(k)-1(g)(6), commonly referred to as the (g)(6) regulations.
The (g)(6) regulations define when a QI is allowed to release funds to the taxpayer. Those rules are as follows:
After the 180-day exchange period expires;
After the 45-day identification period expires, if the taxpayer has identified no replacement property; or
After the 45-day identification period expires and the taxpayer has acquired all replacement properties (prior to the 180th day).
These rules can be confusing and may seem nonsensical, but as a QI, we must follow these rules to the letter.
If a taxpayer identifies two properties within the 45 days and only closes on one of the properties on day 60, any remaining funds must remain with the QI in the 1031 account until the 180-day exchange period expires. Per the regulations, they could still use the funds in the 1031 (no matter how much is left) to purchase the other identified property.
However, if the taxpayer were to identify two properties and close on both, any remaining funds in their 1031 account can be released to the client by the QI, as long as the 45-day identification period has passed.
When trying to research the (g)(6) regulations online, the results can seem involved. As a Qualified Intermediary, Security 1st Exchange is here to assist you during the 1031 process to make sure that things go as smoothly as possible. Always reach out to our team of professionals to help in your successful 1031 Exchange.