"MY EXCHANGE FELL APART. pLEASE SEND ME MY MONEY."

Aug, 2012

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Believe it or not, occasionally an exchange doesn't go according to plan. Any number of things can happen to cause problems. The exchange client ("exchanger" or "taxpayer") can fail to locate and identify suitable replacement properties before the end of the 45-day identification period. Sometimes something will make it so the exchanger cannot close on any of the replacement property he identified. And sometimes the exchanger just changes his mind and decides not to exchange at all.

What happens when something does go wrong? 

LET'S LAY THE FOUNDATION

As you likely already realize, the Internal Revenue Service ("IRS") established a set of Safe Harbor regulations that se dollar-falling-apart.jpg t out guidelines under which a taxpayer can conduct what is known as a Section 1031 exchange. Part of those provisions are what we in the industry refer to as the (g)(6) limitations. The (g)(6) limitations must be stated clearly in the Exchange Agreem en t signed by the taxpayer and the intermediary. What they do, in a nutshell, is specifically limit the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the proceeds from the relinquished property sale prior to the expiration of the exchange period. These restrictions are all-encompassing and must remain in effect throughout the exchange period. The (g)(6) limitations restrict the intermediary from releasing exchange funds except at certain times. The intermediary may release funds to the closing agent of the replacement property when it is ready to close; otherwise, the intermediary must hold the funds until the expiration of the exchange period.

The expiration of the exchange period is not more than 180 days after the closing of the relinquished property, but oftentimes can be sooner. It is the earliest of these events:

1)      After the end of the 45-day identification period if the exchanger has not properly identified replacement property; or

2)      After the exchanger has received all of the identified replacement properties to which s/he is entitled; or

3)      At the end of the 180-day exchange period.

There is one other possibility that is rare and should only be used with the greatest of care. If the taxpayer believes that a material and substantial contingency that is: (a) related to the deferred exchange; (b) provided for, in writing, and (c) beyond the control of the taxpayer and of any disqualified person, other than the person obligated to transfer the replacement property to the exchanger. An example might be if the taxpayer properly identified one replacement property and on day 65 of the exchange, the building on that property burned to the ground. This would likely meet the high standards of this exception.

While it is possible to structure a 1031 exchange outside of the Qualified Intermediary Safe Harbor, doing so will cause the taxpayer to lose the benefits and protections afforded by the Safe Harbor. This creates the probability that the exchange will not only be set aside by the IRS, but will also generate penalties and interest costs.

A much wiser way to conduct the exchange is to keep it within the Qualified Intermediary Safe Harbor. When the taxpayer does so, s/he also elects to comply with the (g)(6) limitations. Let's now look more closely at those restrictions.

FICTION AND FACT ABOUT THE (g)(6) LIMITATIONS

Fiction #1 - All a taxpayer has to do to cancel an exchange is demand return of exchange funds anytime between Day 1 and Day 45.

Fact #1 - Simply not true. Conducting a 1031 exchange within the Qualified Intermediary Safe Harbors created by the IRS in 1991 requires a written Exchange Agreement that contains specific (g)(6) limitations on the taxpayer's ability to receive or control the exchange funds. These limitations set out the times at which the intermediary may release funds to the taxpayer, the earliest of which after the exchange has begun is at the expiration of the identification period (on Day 46) if no replacement property has been identified. There is, therefore, no provision for terminating an Exchange Agreement before Day 46, and the written Exchange Agreements of all Qualified Intermediaries reflect this requirement. (An Exchange Agreement that omits the (g)(6) limitations creates the situation where the intermediary will be determined to be a disqualified party/agent of the taxpayer, and therefore not a true Qualified Intermediary.)

 

Fiction #2 - After properly identifying three properties, taxpayer closes on one of the three, using the majority of his exchange funds. He determines that he will not acquire either of the other two properties and demands immediate return of the unused exchange funds.

Fact #2 - The (g)(6) limitations specifically state that the Exchange Period does not terminate until the taxpayer has received all of the properly identified replacement property to which he is entitled. The taxpayer is entitled to receive all property that is properly identified. So in this instance, the Exchange Period is open until the taxpayer acquires the remaining two properties. Even if the taxpayer has no intention whatsoever of moving forward with the purchase of either of the two remaining properties, the Exchange Period is still open and the taxpayer is entitled to acquire them. The solution for this dilemma must be dealt with prior to the end of the Identification Period by specifying on the Identification Letter that the taxpayer intends to only acquire "one of the following three properties," or by using the word "or" between the three identified properties. In this way, after the taxpayer acquires one of the properties, he is no longer entitled to acquire any more replacement property and the Exchange Period has ended. Remaining funds at that point can be returned to the taxpayer by the intermediary.

 

Fiction #3 - If the taxpayer is unable to negotiate a satisfactory contract for the purchase of the replacement property, the taxpayer can demand immediate return of the exchange funds based on a "material and substantial contingency that is beyond the control of the investor."

Fact #3 - The exception to the (g)(6) limitations known as the "material and substantial" contingency is very narrow. First, it is only available after the expiration of the 45-day Identification Period, so the taxpayer may not make this claim between Day 1 and Day 45. While "material and substantial" is not specifically described in the regulations, the IRS does set out several examples, such as: (a) the replacement property is destroyed, stolen, seized, requisitioned or condemned, or (b) the regulatory [read: government] approval necessary for the transfer of the replacement property cannot be obtained in time for the property to be transferred within the 180-day exchange period. As mentioned above, the material and substantial contingency must: (a) relate to the exchange;  (b) be beyond the control of the taxpayer and any disqualified person; and (c) be in writing. Reasonable consensus within those in the exchange industry is that it is the IRS's position that an economically unfeasible event does not satisfy the "material and substantial contingency beyond the control of the investor" requirement. The asking price being too high or the identified replacement property being taken off of the market does not qualify. Theoretically, the taxpayer could acquire those properties by offering a higher price. While that may not be economically desirable to the taxpayer, it is within his control. Such a situation, therefore, does not meet the material and substantial test.

 

Fiction #4 - In an effort to comply with the regulations, the intermediary provides an Exchange Agreement that contains the (g)(6) limitations, but as a concession to his clients, those limitations are ignored when a demand is made by the taxpayer.

Fact #4 - The reputable and reliable Qualified Intermediary has an appreciation for compliance with all Safe Harbor regulations, including the (g)(6) limitations. His Exchange Agreement language not only contains the (g)(6) limitations, but he takes actions to  avoid having his clients violate them. To do otherwise would create a convincing argument for the IRS to contend that the QI's standard actions effectively amended the terms of the written Exchange Agreement, and therefore the "amended" agreement would fail to contain the mandatory (g)(6) limitations. Taken to the extreme, but within the realm of the possible, the IRS could determine that all exchanges in which such an intermediary participated could be invalid. Reputable Qualified Intermediaries have a fiduciary duty to their clients to keep all of their clients in compliance with the (g)(6) limitations and all other aspects of the Safe Harbor.

 

In conclusion, it is important for exchangers to understand the (g)(6) limitations before entering into an Exchange Agreement. Exchangers should be clearly advised of the limitations upfront. At Iowa Equity Exchange, the (g)(6) limitations are clearly stated in our Exchange Agreement, plus they are stated again in our Letter of Engagement. We have also begun highlighting the (g)(6) section of the Exchange Agreement and requesting the client's initials in a box in the margin to indicate that they have read and understood this important provision of the Safe Harbor. As with all aspects of exchanging, we encourage our clients to ask any questions and, of course, to consult with their tax and/or legal advisors prior to entering into any Section 1031 exchange.

  

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