Tax deferral in a proper 1031 exchange is based upon strict adherence to Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code Internal Revenue Code Section 1031 and the Regulations promulgated under that code section. In fact, there is a distinct emphasis of form over substance throughout the Regulations.
Possible Reasons for Not Completing an Exchange
For example, a taxpayer can have very good reasons for failure to identify replacement property within the 45-day period. He could have suddenly fallen very ill or have had his home damaged in some type of catastrophe. But short of the taxpayer’s location being in a federally-declared disaster area, these valid reasons to identify late are not recognized in the Regulations. This may seem harsh.
Similarly, there are rules that can cause a taxpayer to unwittingly have his return of funds delayed. There are instances in which a taxpayer may have a change in circumstances following the deposit of exchange funds into an exchange account with a qualified intermediary (QI). Or taxpayers may identify one or more replacement properties but still need to terminate the exchange before the end of the 180-day exchange period. In these situations, the taxpayer would be expected to pay capital gains that would be due had he not started the exchange.
When Early Release of Funds is Allowable under the Regulations
The Regulations are very specific regarding the release of funds to the taxpayer. They provide that funds cannot be returned within the 45-day identification period at all or within the 180-day exchange period unless one of the following occurs:
(A) The receipt by the taxpayer of all of the replacement property to which the taxpayer is entitled under the exchange agreement, or
(B) 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
An example of (A) is when a taxpayer identifies only one replacement property within the 45-day period, acquires the property after that period and still has additional cash in the exchange account. Since there are no more possible replacement properties, the funds can be returned. Those excess funds can be distributed, and the taxpayer will recognize gain only on that sum.
In another example, a taxpayer may identify two possible replacement properties, purchase just one and have funds left over. There is still one available replacement property that has been identified and funds remaining, but the taxpayer has no intention of buying the second property, so the funds will need to sit until the 180-day exchange period is through. Often, the qualified intermediary will suggest that the taxpayer make clear in the identification period that he only intends to buy one of the two properties. In this case, once the first property is acquired, excess funds can be paid back to the taxpayer.
In an example of circumstance (B), a Purchase and Sale Agreement for replacement property might contain a contingency providing that the taxpayer will need to obtain a zoning variance for the transaction to go ahead. Failure to obtain it would be a valid reason to terminate the exchange. Short of these limited exceptions, the Regulations do not provide the ability to terminate the exchange on demand, despite the taxpayer being willing to pay the applicable taxes due in the absence of a completed exchange.
IRS Provides Clarity in Private Letter Ruling PLR200027028
After the Regulations were issued, it was generally assumed that termination of the exchange on demand was possible as long as the taxpayer was willing to pay full taxes due. The ability to terminate could not be part of a valid exchange agreement without tainting valid exchanges, however the exchange agreement could be amended to provide for this early distribution.
The IRS settled this uncertainty by the issuance of Private Letter Ruling PLR200027028. The ruling detailed where an exemption to the rule against release might apply. However in the conclusion, the IRS held that in the absence of an occurrence of an event under (A) or (B) above, the exchange agreement could not be amended to allow for early distribution. The ruling states, “Accordingly, we rule that Exchangor’s standard exchange agreement and standard qualified trust agreement, as amended, do not meet the requirements of Section 1.1031(k)-1(g)(6)(iii) of the regulations.”
Does compliance with the IRS position in these instances matter, when the exchange is not going to be carried out? It may not matter from the taxpayer’s standpoint, but the QI is responsible for adhering to a course of conduct outlined by the rules. Acting otherwise jeopardizes the QI’s position with the IRS and could jeopardize other exchanges. There are times when a taxpayer acting in good faith may seek to receive a return of his deposit while agreeing that the normal taxes will be due on the gain. Unfortunately the early return of funds is permissible in limited circumstances, and a taxpayer should make sure those limitations are not an obstacle to entering into an exchange transaction.