One of the surest ways to void an option to defer taxes on the sale of an investment property is to take constructive or actual receipt of the sales proceeds. Let’s discuss what this means and what important steps investors must take to ensure that their ability to complete a 1031 exchange is not jeopardized.
One of the most fundamental rules governing the 1031 exchange process is that an investor cannot have control over their exchange funds from the point that their sale closes until they have fully completed the purchase of their selected replacement properties within 180 days of their closing date. Of course, if an investor is unable to close on previously identified properties and their 180-day exchange period ends, they would be permitted to regain control of their funds which would then be subject to applicable taxes.
While some exchange regulations often permit a degree of latitude in what an investor may claim to successfully defer taxes such in proving that had an “intent” to hold their properties for longer term investments, a violation of the constructive receipt rule would certainly result in the loss of a 1031 exchange tax deferral option.
We have received calls from investors who explain that they had an intent to complete a 1031 exchange but failed to notify the escrow company and received a check for their sales proceeds. It is not pleasant to explain that having an intent to complete an exchange is not sufficient and that it is now too late for them to defer taxes – even if the check remains uncashed.
Fortunately, there several easy-to-follow steps that will safeguard your ability to successfully complete a 1031 exchange.
Inform All Sale-Related Parties That You Intend to Complete a 1031 Exchange
The first step is to inform your sales agent that you are selling an investment property and that you are planning to complete a 1031 exchange. You must do this even if you are not sure if you will be doing an exchange to retain your option to do so. The second step is to review the listing agreement for marketing your property to make sure it explicitly and very clearly states that you may be completing a 1031 exchange. This information will then be included in disclosures that will be provided to potential buyers, their agents, your title company, and to escrow agents who will finalize the sale.
If you are selling your investment property directly and not engaging a sales agent, be sure your sales agreement explicitly states that you intend to complete a 1031 exchange.
Engage a Qualified Intermediary
Plan to open an exchange account with a reputable 1031 Qualified Exchange Intermediary (QI) firm as soon as you and your buyer execute a sales contract. You can begin the QI interview process prior to executing your sales contract, but many QIs will not open an exchange account until you are in contract.
The role of the QI in preventing constructive receipt is critical since they will work closely with the escrow company and accept and hold applicable sales proceeds in separate account under their control pending your decision to reinvest the funds and purchase suitable replacement properties.
Work With a Replacement Property Rep Who Can Help Coordinate Your 1031
There are many steps involved in selling an investment property, finding suitable replacement properties, and successfully completing a 1031 exchange. Even investors who have significant experience buying and selling properties can get overwhelmed when unexpected events occur, and it is easy to lose sight of critical details that can impact your exchange.
When interviewing individuals to assist you in finding replacement properties, be sure to ask them how they can assist you to ensure that all needed steps are taken to result in a successful exchange. While your realtor and Qualified Intermediary should also be overseeing your exchange process, the high current volume of 1031 exchange transactions are putting significant stress on resources and it is well advised to work with a replacement property rep who can take additional responsibility to successfully get you over the finish line.
Follow-up in Writing
Finally, be sure that all instructions and steps in the 1031 exchange process are communicated in writing between all involved parties. Follow-up verbal conversations with an email summarizing what was agreed to and make sure you are copied on all related written communications between all parties.
Summary
The consequences of a failed exchange due to taking constructive receipt of funds can be severe – but easily avoided if you inform all parties of your intent to potentially complete an exchange and have a knowledgeable lead coordinator who can help make sure that no balls are dropped along the way.
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For more information on real estate tax deferral strategies and replacement property options including DSTs, please contact us at 408 392-8822 or via email at info@FGG1031.com.
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