First American Exchange Company

A service from the Society’s 2005 Corporate Sponsor

Release of Funds Prior to Expiration of Exchange Period

Every taxpayer begins an exchange with a clear intention of completing it. Deferring capital gains taxes on low basis property is generally of the utmost importance to all taxpayers. Unfortunately, events do not always go as planned once the relinquished property is transferred and clock has started running for the 45 and 180 day timeframes. Many challenges can arise which would prevent the exchange, entirely or in par, from being completed, many of which could be completely beyond the taxpayer’s control. When situations occur, after properties have been identified and the 45th day has come and gone, the taxpayers want to receive the remaining exchange funds from the Qualified Intermediary (“QI”). At this point, the taxpayers know they will have to pay the tax on their gain, so they ask the QI to return the exchange funds. Much to their surprise, most QI’s will refuse such a request.

The release of funds is governed by IRS Regulation §1.1031(k)-1(g)(6). There are three scenarios under which unused exchange proceeds may be returned to the taxpayer prior to the expiration of the exchange period:

1. The 45 day identification period has expired and no property has been identified.

2. The taxpayer has received all of the replacement property to which the taxpayer is entitled to receive under the exchange agreement.

3. The occurrence of a material or substantial contingency that relates to the exchange, is provided for in writing, and is beyond the control of the taxpayer.

Commonly referred to as the “g(6) restrictions”, this language is a required part of any exchange agreement. The QI industry is reluctant to make exceptions, for fear that such exceptions may taint all of their exchanges, not just those where funds were disbursed absent the occurrence of a g(6) event. Currently there is no degree of comfort from the IRS for the QI that this will not be the case.

A QI holds the exchange proceeds to prevent actual or constructive receipt of the funds by the taxpayer. To avoid any issues of constructive receipt, the QI must be independent of the taxpayer. If the QI releases funds in violation of the terms of its own exchange agreement (not to mention the IRS Regulations), there is certainly a strong inference that the QI is not truly independent of the taxpayer. A QI that routinely ignores the terms of its exchange agreement risks becoming an “accommodating accommodator”, and thus bringing all of its exchanges into question in the event of review or audit by the IRS.

The first scenario outlined in the Regulations, regarding the failure to identify replacement property, is clear. If the taxpayer has not identified any potential replacement property, the exchange fails, so there is no reason for the QI to hold the exchange proceeds. If the taxpayer wants to cancel the exchange within the identification period, most QI’s will require that the taxpayer wait until the 45 days have passed before releasing any funds.

If the taxpayer has identified property, but is still within the 45 day period, the identifications can be revoked. Once revoked, the funds can be released upon the expiration of the 45 day identification period.

Most taxpayers do identify property, which brings us to the second scenario. The obvious question is this: What does it mean to be “entitled” to receive property? The most common interpretation is that the taxpayer is entitled to receive any property that has been identified. Many taxpayers will identify multiple properties, even if they only intend to acquire one of them. What happens after they acquire one property, have other identified properties (which they do not want), and have money left over in the exchange account?

This issue was addressed by the court in Florida Industries Investment Corporation and Subsidiaries v. Commissioner, T.C. Memo 1999-346, aff’d per curium in an unpublished opinion (11th Cir. 2001). In that case, the taxpayer acquired a replacement property in an exchange that the court found to be a “good” exchange. After that transaction, the taxpayer engaged in other activities that showed it had never truly relinquished control of the exchange proceeds. As a result, the court not only voided the subsequent attempts to acquire replacement properties, it voided the exchange ab initio, including the “good” exchange!

Thus, under Florida Industries, a taxpayer that acquires replacement property but still has identified property available should leave the exchange funds with the QI until the end of the exchange period. An early release of funds could result in the entire transaction being disallowed.

To resolve this problem, taxpayers should consider identifying properties in the alternative. For example, the taxpayer might identify three potential replacement properties, stating: “I intend to acquire one of these three properties as my replacement property. Once I have acquired one property, I will have received all of the property to which I am entitled.”

The final scenario, the occurrence of a material or substantial contingency that has been provided for in writing and is beyond the control of the taxpayer, is rarely invoked. The biggest problem is that such contingencies are rarely provided for in the contract. Examples of such contingencies are zoning requirements, meeting certain environmental standards, etc.

What if the taxpayer and the QI provide for the early release of funds in the exchange agreement, prior to the transfer of the relinquished property? PLR 200027028 outlined a request by a prominent QI to change their exchange agreement to allow for the early release of funds in the event that the taxpayer, after good faith negotiation, was unable to reach an agreement with the replacement property seller. The IRS refused to go along. They concluded that “…it is within the [taxpayer’s] control to meet the seller’s demands or walk away from an uneconomic business deal.”

Perhaps the best approach to this problem is to make sure that the taxpayer is aware of the g(6) restrictions before they enter into the exchange. A well drafted exchange agreement will highlight these restrictions and require the taxpayer to initial that specific paragraph. This is to signify that they have read and understand the rules.

Every temptation is present for the QI to release the funds to the taxpayer at their request for relationships and keep the client happy; however, in light of Florida Industries and PLR 200027028, the best course of action is to wait until the end of the 180 exchange period.

All information contained herein is provided as a matter of courtesy to our clients. First American Exchange Company, its officers and agents make no representations as to the completeness and applicability of the information contained herein to each individual taxpayer. As a Qualified Intermediary, First American Exchange Company is precluded for providing tax or legal advice to its clients. Please consult your own independent tax or legal advisor regarding your specific circumstances.

Hugh E. Pollard
Certified Exchange Specialist®
Vice-President, Regional Exchange Manager
First American Exchange Company, LLC
30 N. LaSalle Street, Suite 310
Chicago, IL 60602
312.917.7206 Phone
630.281.6203 Fax
Email: hpollard@firstam.com

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