One potential pitfall multifamily property investors want to avoid in a 1031 exchange is constructive receipt. This occurs when you, a cash-basis taxpayer, are considered by the IRS to have control of the proceeds of the sale of the relinquished property, even though you did not formally take receipt of that money. This will nullify your 1031 exchange, so you should be aware of what constructive receipt is and how to steer clear of it.
What Is Constructive Receipt?
A 1031 exchange allows you to defer capital gains tax while you exchange your property for other property of like kind and of equal or greater value. Since this is an exchange, you should not touch any of the money from the sale of the relinquished property; a qualified intermediary (QI) is used to facilitate the exchange. A QI can be anyone who is not disqualified under IRC 1031(k) for being too closely connected to you and has not been in a disqualifying capacity in the last two years. The QI acquires the relinquished property from you before the sale, and then handles the sale of that property and the purchase of the replacement. Any money left over is subject to taxation.
The only reason there is any cash present at all in the transaction is because the 1031 exchange is a delayed exchange. In other words, you do not have to relinquish and replace properties simultaneously, as long as the money stays out of your hands. Although the principle may be unambiguous, the practice of avoiding payment for the relinquished property is complicated by the doctrine of constructive receipt.
According to IRC 1031(k), “The taxpayer is in constructive receipt of money or property at the 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 or so that the taxpayer can draw upon it if notice of intention to draw is given.” The taxpayer must sign an agreement with the QI that “expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary.”
Avoiding Constructive Receipt
Constructive receipt may occur if the relinquished property has been used as collateral for a business loan other than its mortgage. There are ways to take the lender’s interests into consideration in a case like this by structuring the sale correctly and through action taken by the QI. But this is an exceptionally complex process best carried out by experienced professionals.
Other possible incidents of constructive receipt include letting sale proceeds of the relinquished property pass through the hands of anyone who is your agent, such as a lawyer. You will also trigger it if you give the QI or (anyone else) instructions for the use of those proceeds. This can include using proceeds to pay sale fees that are not categorized as exchange expenses. Nor can you pay earnest money on the replacement property—that is another function of the QI.
If you do a partial 1031 exchange, creating taxable boot intentionally by exchanging your relinquished property for one of lesser value, you can take receipt of the boot money after the 180-day exchange period is over. If you were to claim that money earlier, it would nullify the 1031 exchange. If you create a deferred sales trust while selling your relinquished property, constructive receipt rules similar to those described here will govern your relationship with the trustee.
Constructive receipt restrictions require close attention and sometimes detailed expert knowledge. They are not a hindrance to making a 1031 exchange, but they do emphasize the need for professional guidance at all steps in the exchange process.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country, and employ a team of experts who can help you hone your investment strategy.
For more articles like this one, check out our 1031 exchange blog posts.
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