Suppose that as a closing attorney, you have just closed a purchase transaction and recorded the deed. You inform the seller that he can pick up his sales proceeds, but the seller responds, "Oh, by the way, I want to do a 1031 exchange." Is it too late? What about the client who transfers relinquished property in a properly structured exchange, acquires replacement property with part of the exchange funds, and now wants the remaining exchange funds? Can he get his money? Both of these scenarios involve the possible constructive receipt of exchange funds by the taxpayer. As tax-deferred exchanges become more commonplace, it is important to recognize and understand constructive receipt issues so that exchange clients don't encounter unexpected tax consequences.

The 1991 Treasury Regulations
In 1991, the Treasury Department issued its final regulations governing non-simultaneous exchanges and provided safe harbor for taxpayers to utilize. In regard to constructive receipt, Tres. Reg. § 1.1031(k)-1(f)(1) states that if the taxpayer is in constructive receipt of money or other property, "the transaction will constitute a sale and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property." Subsection (f)(2) elaborates further, saying, "[t]he taxpayer is in constructive receipt of money or property at the time the money or property is credited to the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time or so that the taxpayer can draw upon it if notice of intention to draw is given." In other words, it is not merely sufficient for exchangers to avoid physically touching exchange funds, and the penalty for having access in any form during the transaction is fatal.

Qualified Intermediary Safe Harbor
The most widely-employed safe harbor under the regulations has been the use of a qualified intermediary. The first step to avoid constructive receipt is to ensure that the qualified intermediary is not related to, or an agent of, the taxpayer. Any person, including an attorney, investment banker, accountant or real estate agent who has represented the taxpayer in any matter during the last two years will be considered an agent and, therefore, be disqualified from serving as qualified intermediary.

The second consideration to avoid constructive receipt of the sales proceeds by the taxpayer is to ensure that the exchange agreement is in place by closing of the first relinquished property. Additionally, the exchange agreement must restrict the taxpayer's right to receive funds generated from the sale of the property. If closing occurs before these limitations are in place, the taxpayer technically has the legal right to demand the sales proceeds. Therefore, he is in constructive receipt of funds, regardless of whether or not he has actually received the funds, and the transaction will be deemed a taxable sale.

Therefore, it is advisable, well before closing, to routinely inquire of sellers if there is any desire to structure a 1031 exchange. The seller may not have considered this option, or he may not even be aware that an opportunity to defer capital gains taxes exists. Real estate professionals dread that telephone call received weeks, days or even hours after a closing from an angry taxpayer who discovered that it is too late to do an exchange.

Essential Elements of the Exchange Agreement Governing Constructive Receipt
Treasury Regulation § 1.1031(k)-1(g)(6) sets forth the restrictions and limitations that must be present in an exchange agreement in order for the taxpayer to fall within the safe harbors and avoid constructive receipt of exchange funds. The agreement must provide that the taxpayer has no right to receive, pledge, borrow, or obtain the benefits of the money or other property the qualified intermediary is holding before the end of the exchange period. The exchange period is the 180-day maximum time frame between the transfer of the relinquished property and the acquisition of the replacement property. However, the exchange agreement may provide for an early release of funds to the taxpayer in the following circumstances:

a) If no replacement property has been identified, the taxpayer may receive funds after the 45-day identification period expires;
b) If the taxpayer has identified replacement property, the taxpayer may receive remaining funds after he has acquired all of the replacement property to which he was entitled to acquire under the exchange agreement.

If the taxpayer or qualified intermediary waive any of the g(6) limitations contained in the exchange agreement, the taxpayer will then be considered in constructive receipt of the funds, and the entire transaction will be deemed a sale and purchase rather than an exchange.

Practical Examples
Scenario One: Under a properly structured exchange agreement with a qualified intermediary, the taxpayer transfers relinquished property worth $100,000.00, and thirty days later he identifies and acquires one replacement property for $90,000.00. When may he receive the remaining $10,000.00 under the required exchange agreement limitations? He must wait until the end of the 45-day identification period to receive the additional $10,000.00. Under the exchange agreement, he is entitled to identify additional replacement property within the 45-day identification period. But, if he does not identify additional replacement property, he will have acquired all the property he was entitled to acquire under the exchange agreement, and may receive the remaining funds on day 46.

Scenario Two: In a slightly different scenario, let us assume that the taxpayer transferred relinquished property worth $100,000.00, and thirty days later identifies three replacement properties. On day 50, he acquires one of the identified properties for $90,000.00. When may he receive the remaining $10,000.00? The g(6) limitations allow him to receive remaining funds only after he has received all the property he was entitled to receive. Because he identified three properties, he must wait until after the 180-day exchange period expires to receive his remaining exchange funds. Otherwise, he will have waived the restrictions in the exchange agreement and be in constructive receipt.

The early release of $10,000.00 in the preceding examples would not simply generate tax consequences on the $10,000 boot received by the taxpayer, but would put the taxpayer in constructive receipt and destroy his entire exchange. A possible solution to the problem in Example Two may be a carefully drafted replacement property identification. Many taxpayers routinely identify alternate properties, even if they only plan to acquire one of them. If the taxpayer had stated in the identification his intention to acquire ONE PROPERTY ONLY of the three properties listed, he could argue that he had received all the replacement property he was entitled to receive under the exchange agreement. This careful attention to wording of the replacement property identification would enable him to receive the remaining funds after acquiring one identified replacement property. The replacement property identification may not be altered or amended after the 45-day identification period expires, so the taxpayer's intentions should be carefully considered when identifying the replacement property.

Summary
Early recognition of exchange opportunities is vital so that an exchange can be structured within the safe harbors. A properly drafted exchange agreement executed before closing ensures the taxpayer that he will not be in constructive receipt of funds generated from the sale. A review with the taxpayer of the restrictions that the exchange agreement places on his exchange funds will enable the taxpayer to comply with the constructive receipt requirements and properly plan the transaction. The safe harbors provided in the 1991 Treasury Regulations have made exchanging real property easier and safer than ever before. Choosing a qualified intermediary who also understands constructive receipt requirements can help your client achieve his exchange goals successfully.

Carol A. Hayden is Vice President of Investors Title Exchange Corporation. She can be reached at chayden@1031itec.com or 800-326-4842.