Tax deferral through a 1031 exchange is based on strict adherence by Qualified Intermediaries (QI) 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. In fact, there is a distinct emphasis of form over substance throughout the Regulations.
Should a taxpayer fail to identify replacement property within the 45-day period, the Regulations are very specific regarding the release of funds to the taxpayer. They indicate, under no circumstances can exchange funds be returned within the 45-day identification period 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, 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 and still has additional cash in the exchange account. Since there are no more possible replacement properties, the remaining funds can be distributed to the taxpayer, who will recognize taxable gain only on the remaining sum.
In another example, a taxpayer may identify two replacement properties, go past the 45-day identification period, decide to purchase only one. Since there is still one identified replacement property available, the QI must hold any remaining exchange funds until the 180-day exchange period has expired even though the taxpayer has no intention of buying the second property. Often, the qualified intermediary will allow the taxpayer to make clear during the identification that they only intend to buy one of multiple properties (or in an order of preference). In such a case, once the first-choice property is acquired, remaining funds can be disbursed because the exchange is terminated.
As an example of circumstance (B) above, a Purchase and Sale Agreement (PSA) for replacement property might contain a contingency providing the taxpayer will need to obtain a zoning variance from a governmental agency for the transaction to close. Failure to obtain such a variance would be a valid reason to cancel the PSA and terminate the exchange allowing the taxpayer to receive the exchange funds early.
In the absence of a fact pattern falling within the limited exceptions explained above, the Regulations do not provide the ability to terminate the exchange on demand, despite the taxpayer being willing to pay the applicable taxes due. The Regulations and the provisions of the Agreement between the Exchanger and the Qualified Intermediary, establishing the Exchanger’s intent to complete a Like-Kind Exchange and detailing each party’s roles and responsibilities. The Exchange Agreement must detail the exchange in accordance with the deferred exchange regulations. Exchange Agreement signed by the taxpayer require the QI to hold the line on early distribution of exchange funds.
Position of IRS in Private Letter Ruling PLR 200027028
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 the 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 attempted to settle 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 IRS also used the ruling to expand upon (B)(3) above pertaining to what constitutes “beyond the control of the taxpayer”. The Ruling suggests that this means “…actions of a party not involved in the exchange (government agency’s seizure, requisition, or condemnation of the replacement property or government agency’s failure to approve a request to rezone or approve the transfer of the replacement property) or an act beyond anyone’s control (destruction of the replacement property) are contingencies that are beyond the owner’s control”. It goes on to state “Unlike the qualifying contingencies in the example, it is within the owner’s control to decide to meet the seller’s demands or walk away from an uneconomic business deal”.
IRS Notice 2020-23
On April 9, 2020, the IRS issued Notice 2020-23 Providing Additional Relief for (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s Affected by the COVID-19 Pandemic. Affected (“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s performing Section 1031 exchanges are included in the amplified relief. Among other subjects, this Notice extends the 45-day identification period and the 180-day exchange period for taxpayer/exchangers whose deadlines were due on or after April 1, 2020. The deadlines for those exchangers to identify replacement property and/or acquire replacement property are now July 15, 2020. The QI could continue to hold the funds in the outside chance of a subsequent amendment to Notice 2020-23; however, it’s doubtful the taxpayer could claim a valid exchange if in “actual or constructive receipt” unless carved out by a modification down the road.
Does compliance with the IRS position in these instances matter, when the exchange is not going to be carried out and the taxpayer is willing to pay the taxes? It may not matter from the taxpayer’s standpoint, but the QI is responsible for adhering to a course of conduct outlined by the Regulations and other rulings. Acting otherwise jeopardizes the QI’s position with the IRS and could jeopardize the exchanges of numerous other taxpayers. There are times when a taxpayer acting in good faith may seek to receive a return of their exchange funds while agreeing that the normal taxes will be due on the gain. Unfortunately, early return of funds is only permissible in the limited circumstances outlined above and a taxpayer should make certain those limitations are not an obstacle to entering into an exchange transaction.