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"Constructive Receipt" In 1031 Exchanges

A sale of property for cash or other property is generally a taxable event unless another provision of the Internal Revenue Code permits tax deferral. Where tax deferral is available, the IRS and courts generally require strict compliance with the statute or regulations authorizing such deferral.

One of the most commonly used statutes providing tax deferral is Internal Revenue Code § 1031. This provision permits tax deferral when "like kind" property is exchanged for other like kind property. Although the exchange requirement might seem simple at first blush, Section 1031 and the regulations promulgated by the Treasury under authority granted by Congress set forth specific procedures and documentation requirements that must be met at the time the relinquished property is transferred to a buyer if the "exchange" will involve a sale of relinquished property for cash or other non-like kind property. This sort of transaction is commonly referred to as a "delayed exchange." A taxpayer's intent to purchase replacement property following a sale is not enough to qualify for tax deferral under Internal Revenue Code §1031.

The documentation requirements mostly relate to an income tax notion called "constructive receipt." Under this doctrine, a taxpayer has received property that the taxpayer controls or has access to, even if the taxpayer does not actually have possession of the property. Section 1.1031(k)-1(f)(2) states that a "taxpayer is in constructive receipt of money or property at any 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."

The regulations describe various ways of avoiding the application of the constructive receipt doctrine where relinquished property is sold for cash or other like kind property in the first phase of a tax deferred exchange (e.g., the like-kind property is not merely swapped). Specifically, the regulations create several "safe harbor" arrangements, including the use of a "qualified intermediary", "qualified trust" or "qualified escrow" to hold the sale proceeds during the period between the sale of the relinquished property and purchase of replacement property. Each of the foregoing arrangements requires the taxpayer to execute a written agreement that adequately limits the taxpayer's right to receive, pledge, borrow or otherwise obtain the benefit of the sale proceeds during the exchange period.

A recent Tax Court case illustrates the problem that arises when a delayed exchange is not properly documented at the time of the relinquished property sale. In Crandall vs. Commissioner, T.C. Summ. Op. 2011-14, 2011 TNT 32-7, the taxpayer sold an undeveloped parcel of land in Arizona that had been held for investment. The taxpayer intended to exchange out of the Arizona property and into a property in California located closer to the taxpayer's residence. Upon the sale of the Arizona property, the buyer's purchase money was deposited in an escrow account with the title company handling the closing in Arizona.

However, instead of utilizing one of the safe harbor arrangements authorized in the regulations, such as using a qualified intermediary to facilitate the exchange, the taxpayer merely left the proceeds in the escrow account at the title company, and told the escrow officer that he was doing an exchange. The taxpayer later instructed the Arizona title company to transfer some of escrowed funds to a title company in California engaged to close a purchase of other investment property for the taxpayer. The property being acquired in the second escrow met the "like-kind" requirement under Section 1031.

The IRS subsequently disallowed the exchange on the ground that the taxpayer had constructive receipt of the sale proceeds, and assessed a tax on the sale, interest on the underpayment of tax and penalties. On the taxpayer's appeal, the Tax Court determined that the transaction was a taxable sale followed by a subsequent purchase because the escrow agreement did not expressly restrict the taxpayer's access to and use of the funds held in the escrow account.

Lessons learned from Crandall include:

• Although the taxpayer intended to set up a transaction that qualified for a 1031 exchange, it is well established that a taxpayer's intention to take advantage of tax laws does not determine the tax consequences of their actual transactions. [See Bezdjian v. Commissioner (1988) and Carlton v. United States (1960).]

• The reinvestment of proceeds from a cash sale of one investment property into a second property will not qualify for the tax deferral benefits under Section 1031. [See Greene v. Commissioner (1991); Coastal Terminals, Inc. v. United States (1963); Estate of Bowers v. Commissioner (1990); Lee v. Commissioner (1986).]

• Since the escrow account did not limit the taxpayer's right to receive, pledge, borrow or otherwise obtain the benefits of the proceeds nor anything else to properly reflect the transaction as a 1031 exchange, the account was not deemed a qualified escrow account.

• It is essential to consult with a Qualified Intermediary and your tax advisor when contemplating a delayed exchange. Exchange documents must be executed prior to the closing of the relinquished property, and these documents must place adequate restrictions upon the use of the sale proceeds to avoid constructive receipt issues.

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