Occasionally, a taxpayer will request the return of his or her exchange proceeds in the middle of a §1031 exchange. But it is important to consider the consequences. For example, a taxpayer could trigger a capital gains liability if he or she identifies multiple replacement properties, acquires one of them, decides not to complete the rest of the exchange, then requests the return of the remaining proceeds from the qualified intermediary (QI).
Treasury Regulations require that the QI place “substantial restrictions” on the taxpayer’s ability to access any funds held in the exchange account. Furthermore, Treasury Regulations §1.1031(k)-1(g)(6), widely known as the “(g)(6)” restrictions, require that these restrictions be built into the exchange agreement. This would specifically limit the taxpayer’s ability “to receive, pledge, borrow or otherwise obtain benefits of money or other property before the end of the exchange period”. According to this subsection, a taxpayer may only have access to the money and/or other property if:
(a) all replacement properties identified in the exchange have been acquired, or
(b) A material and substantial contingency that had been identified in writing at the time of identification, and is beyond the control of the taxpayer, occurs after the end of the 45-day identification period.
Obtaining early release of exchange proceeds requires careful advance planning. Think about these two main strategies. First, if the taxpayer is within the 45-day identification period, then he or she should revoke the identification of the remaining properties. By doing this, the taxpayer will be deemed in “receipt of all of the replacement properties to which the taxpayer is entitled under the exchange agreement” (§1.1031(k)-1(g)(6)(a)) and the remaining proceeds can be released.
Second, the taxpayer should consider placing contingencies in the identification documents so that he or she has more options to claim that a “contingency beyond his control” has occurred. As an example of this would be a zoning variance that was requested and denied. This could be regarded as material and substantial, permitting the early release of the proceeds by the QI.
As with other aspects of tax deferred exchanges, advance planning can minimize otherwise problematic situations. As always, Wilmington Trust 1031 Exchange LLC recommends that you consult with your legal or tax advisor.
IRC Section 1031 allows taxpayers to defer the gain on the disposition of business or investment real estate, if that real estate is replaced with like-kind real estate, within specific timeframes. Consult your tax or legal advisor for additional information on the requirements and limitations of such exchanges. Wilmington Trust 1031 Exchange LLC is a wholly owned subsidiary of Wilmington Trust, N.A. *Wilmington Trust 1031 Exchange LLC does not provide tax or legal advice to clients.