What is “Constructive Receipt” in a 1031 Exchange?

There are many terms and definitions in the realm of 1031 exchanges that can be confusing to anyone outside the real estate or tax industry. In this article, we are going to explain what “constructive receipt” means in a 1031 exchange and offer some tips for avoiding it.

Constructive Receipt

In 1031 exchange terms, “constructive receipt” means that the person conducting the 1031 exchange has obtained control over the sales proceeds (either directly or indirectly). Why is this bad? Because it violates one of the fundamental rules of the 1031 exchange – that you must move all of your exchange proceeds into a replacement property.

When you effectively receive your sales proceeds you have just received income that is subject to capital gains taxes. This is exactly what you’re hoping to avoid when conducting a 1031 exchange.

The Role of the Qualified Intermediary

One of the many benefits of working with a qualified intermediary during your exchange is that they can insulate you from receiving any of the net proceeds from the sale of your relinquished property. They do this by holding the net proceeds for you during your exchange period and transferring them over to the replacement property at the time of closing.

Twin Cities 1031 Exchange Services

The Minnesota qualified intermediaries at CPEC1031 have been helping taxpayers with their 1031 exchanges for decades. If you’re looking to defer taxes on the sale of real property, contact us today for help with your exchange. Our intermediaries can prepare all the necessary documents for your exchange, and advise you on best practices every step of the way. Contact us today at our downtown Minneapolis office to get started with your exchange.

• Start Your Exchange: If you have questions about 1031 exchanges and constructive receipts, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Tips for Doing a 1031 Exchange with a Significant Other

When a taxpayer is doing a 1031 exchange, they may want to buy their new replacement property together with another person. Maybe they want to buy the replacement property with their significant other or partner, for example.

The Problem with Proceeds

The problem with this generous idea is that in order for the exchange to be respected, all of the proceeds from the relinquished property need to be earmarked and used exclusively for that taxpayer’s exchange.

If the proceeds from the relinquished property are utilized to buy someone else's interest in the replacement property, the IRS will say:

"These funds were earmarked to buy the taxpayer’s interest in the replacement property but instead were used by someone else who is not the exchangor’s interest in the property. We don't see that as being a continuation of investment by the taxpayer.”

So you may inadvertently cause the recognition of gain as to any proceeds that were sidetracked and used to basically ante up someone else's interest in the replacement property.

The Best Course of Action

The better course of action is to have the taxpayer that relinquished the property use their proceeds solely for their purchase of the replacement property. If someone else is coming in as a cold purchasor they should bring in their proportionate share of the down payment and contribute their cash out of their pocket so that they have a place at the table that they pay for out of their own funds.

• Start Your Exchange: If you have questions about 1031 exchange funds, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Exchange Tips for Tenancy in Common Property

A lot of times people own real estate in a partnership or LLC that's taxed as a partnership. If the property goes up in value some of the partners may be inclined to sell the underlying real estate while other partners are not so inclined because they don't want to pay the taxes.

This divergent opinion between the partners can be exasperated if there's been a death of one of the partners and the heirs of the now-deceased step into the partnership with a stepped-up basis and perhaps a more cavalier attitude about selling the underlying real estate. Because they may not have much of a tax burden if the property is sold, they may be less concerned about the tax consequences of a sale.

Setting up a Tenancy in Common

Furthermore, they may not want to be in a partnership with all the other folks. So when this sort of divergent opinion exists it may be a prudent step to bifurcate the ownership of the asset so that rather than having a partnership we would have a tenancy in common. If a sale were to ever occur, the exchange minded folks could be in one entity, and the cavalier folks that have a high basis and are less concerned about taxes would be in a separate distinct tax-paying entity.

When the sale occurs, hopefully we have two sellers on the purchase agreement, and two sellers that are separately 1099’d by the title company. The exchange minded group can set up their proceeds to go with a qualified intermediary and defer their gain, while the cavalier high basis folks that are less concerned with the tax can simply take their share of the proceeds and go.

Give Yourself Time

When do you want to set up this bifurcation? Do you want to set up the split up on the eve of the closing right before you sell the relinquished property? Do you think the IRS will respect a last minute switch? Probably not. The better course of action is to have this conversation amongst the partners early, before there's even a tacit agreement to sell the property and to break up the property well in advance of any proposed sale. Let some time pass after the break up before you actually sell the property. The IRS is much more likely to respect a reconfigured ownership arrangement if it is done well in advance of any sale and some time has passed.

1031 Holding Requirement

Furthermore, remember there's a holding period requirement in section 1031 that the relinquished property must have been held for investment or business purposes. If you do a drop and then a swap immediately you may not have held your property for a sufficient period to satisfy the requirements of 1031.

• Start Your Exchange: If you have questions about 1031 exchanges of TIC property, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Exchange Cancellation Fees

If you call a qualified intermediary on short notice and ask them to prepare a set of 1031 exchange documents, they're going to jump through a lot of hoops – collecting information, reading the purchase agreement and title report, interfacing with the escrow and title company, and generating some very technical 1031 documents that are specifically tailored to your transaction.

Cancelling a 1031 Exchange at the Last Minute

What if the seller decides to not do a 1031 exchange after having this fire drill to prepare their 1031 documents? That's fine - you don't have to do a 1031 exchange. It's a free country. But you probably have a moral and perhaps legal obligation to compensate the qualified intermediary for stopping everything and working exclusively on your transaction to get the 1031 prepared.

It's common if the intermediary has prepared, circulated, and sent out your 1031 documents for the intermediary to charge a cancellation fee if, before the closing of the relinquished property, the taxpayer decides not to proceed with the 1031 exchange.

• Start Your 1031 Exchange: If you have questions about 1031 exchange cancellation fees, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

Can I do a 1031 Exchange of Underwater Property?

Sometimes investors will buy a property, it'll go up in value and when the value is high they'll refinance the property and extract a lot of the equity. Oftentimes, the property will then decline in value such that the debt on the property exceeds the value of the underlying collateral property.

A Potential Tax Problem

So now if you sell that property or have an involuntary sale such as a foreclosure, you may find that you have a sale for tax purposes and that you have a gain on the disposition (because your gain is determined by the difference in the debt relief and your basis). So you may have a low basis, high debt amount particularly if you're giving the property back to the bank. You may have a tax problem because for tax purposes you've conducted a sale in which you have a gain, but in reality you have no cash proceeds because your property is under water.

1031 Exchanging Underwater Property

How do you do a 1031 when you're trying to defer a gain and you have no sales proceeds to reinvest into a replacement property?

The answer is you have to acquire a replacement property - typically the target would be highly leveraged replacement property in which you don't have to put a lot of cash down. Somehow you're going to have to scrape together enough financial resources to acquire a replacement property of equivalent or greater value and which would have enough debt associated with it that you'll be able to offset the debt relief on your old relinquished property.

You may have to scrape, scrimp, beg and borrow to acquire the down payment to get a sufficiently big enough replacement property to cover all the debt relief of the disposition of your old relinquished property. But the benefit of doing so is you keep the taxman at bay and defer those gains indefinitely into the new property.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges of underwater property, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved