This article explains the control an investor may assert over the purchase and improvement of replacement property needed to complete a §1031 transaction.

Conduct ancillary to direct deeding

In a delayed §1031 transaction, the real estate sold by an investor is transferred directly to the buyer of the property. Taxwise, the sale is the investor’s first step in a two-step transaction, called a delayed exchange.

Later, when the investor purchases replacement property, the seller of the property will transfer it directly to the investor to complete the second and final step in the §1031 transaction.

 

A §1031 transaction is called an exchange even though an actual exchange of property does not occur.

Taxwise, a §1031 transaction is called an exchange or a delayed exchange even though an actual exchange of property by the investor does not occur.

Consider an investor who sells §1031 property, called like-kind property, to a buyer who agrees to cooperate with the investor’s completion of a §1031 transaction. [See first tuesday Form 159]

A buyer’s trustee, also called a §1031 trustee, is chosen by the investor to hold the net proceeds from the sale of the investor’s property. The funds will be placed in an interest-bearing trust account to fund the investor’s purchase of the replacement property. Thus, the buyer’s performance of his promise to cooperate in the investor’s §1031 transaction is completed.

Editor’s note — The buyer’s trustee is sometimes called an accommodator or facilitator. Their arrangements for holding the sales proceeds typically are not properly structured as the receipt of trust funds, resulting in an excessive risk of loss to the investor.

Neither the buyer nor the §1031 trustee have any obligation to locate, research, approve or take title to the replacement property. The trustee’s sole task is to fund the investor’s purchase of replacement property from the sales proceeds held in trust. [Biggs v. Commissioner (5th Cir. 1980) 632 F2d 1171]

Figure 1

Delayed exchange schematic

In the first step of a delayed §1031 transaction, the investor sells and deeds his property directly to a buyer. [See Step 1]Prior to closing, the buyer cooperates with the investor by establishing a trust and naming a buyer’s trustee who will receive the net sales proceeds and prevent the investor’s constructive receipt of those proceeds. The cash proceeds and any notes carried back on the property sold by the investor are made payable by escrow to the buyer’s trustee and delivered to the trustee on closing.

The buyer’s trustee, under the trust agreement, impounds the cash funds in an interest-bearing trust account and collects installments on any carryback note. [See Step 2]

Later, on the investor’s instruction, the buyer’s trustee disburses the money and assigns any carryback paper to fund the purchase of acceptable replacement located by the investor. [See Step 3]

If a carryback note is created to pay part of the purchase price of the replacement property, the investor signs the note and trust deed and hands them to escrow. [Step 4]

To close out the §1031 transaction, the replacement property purchased is deeded directly to the investor. [Step 5]

Should any unused cash remain with the trustee after the replacement property is purchased, those funds may be delivered directly to the investor by the trustee or through escrow on closing the purchase.

Insert Schematic here

Any purchase contract

The investor may use any type of contract to purchase the replacement property, including:

  • a purchase option;
  • a purchase agreement;
  • a purchase escrow, with or without an underlying purchase agreement or option; or
  • an exchange agreement.

The investor locates the replacement property and enters into a purchase agreement with the seller to buy the property.

When the purchase escrow on the replacement property is ready to close, the buyer’s trustee, on instructions from the investor, disburses the funds held in the trust account to the purchase escrow for the investor’s account and use as a down payment on the replacement property.

On closing of the purchase escrow, the investor, as the buyer of the replacement property, takes title to the property directly from the seller.

Editor’s note — When an accommodator holds the trust funds, he occasionally and unnecessarily takes title to the replacement property before deeding the property to the investor. This step is not required in a §1031 transaction. [Barker v. Commissioner (1980) 74 TC 555]

Full involvement in the purchase

When purchasing the replacement property, the investor, acting as the buyer, may perform any of the following acts:

  • negotiate the price and terms for payment of the price, as well as all conditions and contingencies;
  • make a good faith deposit with the purchase offer, payable to escrow, using his own funds or funds held by the buyer’s trustee;
  • enter into the purchase agreement or option, and sign escrow instructions as the named buyer;
  • satisfy or waive conditions and contingencies;
  • oversee and direct renovation or construction on the property prior to closing, and assume liability for any funding such as the co-signing or guaranteeing of a construction loan. However, the investor may not undertake personal liability for the renovation or construction of improvements, nor may he take title to the property or sign on the trust deed securing the construction loan [Coastal Terminals, Inc. v. U.S. (4th Cir. 1963) 320 F2d 333];
  • originate refinancing or further financing on the replacement property concurrent with taking title to the replacement property to complete the §1031 transaction;
  • advance at any time any additional funds or properties necessary to fund the closing of the purchase escrow on the replacement property;
  • execute any carryback notes and trust deeds which finance the purchase of the replacement property;
  • assign to a warehousing agent the rights to purchase and take possession of the replacement property prior to the sale of the investor’s property, a so-called reverse exchange; and
  • receive all the interest earned on the net sales proceeds held by the buyer’s trustee, less trustee charges. [Starker v. United States (9th Cir. 1979) 602 F2d 1341]

Documenting the transaction

The investor’s ability to complete a §1031 exchange should be noted somewhere in the documentation.

 When a potential replacement property is located, and before an offer to purchase is submitted, the broker should prepare an Exchange Profit and Basis Recap Sheet.The broker or agent will then review the figures in the recap sheet to analyze the §1031 tax consequences of purchasing this property. [See Form 354]

Also, a cost sheet will be prepared on the replacement property to determine the amount of funds which, in addition to those held by the buyer’s trustee, will be needed to close the purchase escrow, such as for prorations, adjustments and transactional charges. [See first tuesday Form 311]

The investor’s ability to complete a §1031 exchange should be noted somewhere in the documentation for the transaction by either:

  • a mutual §1031 cooperation clause in the purchase agreement [See first tuesday Form 159 §1]; or
  • supplemental escrow instructions worded to prevent the investor’s receipt of the net sales proceeds on closing. [See Forms 172-2 and Form 173-2]

The delayed §1031 transaction is a series of steps, from the beginning of negotiations on the property sold to the completion of acquisition of ownership of the final replacement property. Each step is an integral part of the entire §1031 transaction.

Taxwise, the steps of the transaction are not taken apart and separately analyzed to determine any interim economic or legal consequences. All steps together are treated as one complete transaction, and the tax consequences are then analyzed based on whether any net mortgage boot or cash boot was received out of the property sold. [Starker, supra]

The only restrictions on how the §1031 transaction must be completed are:

  • the investor must avoid actual and constructive receipt of the net proceeds from the property sold [Carlton v. United States (5th Cir. 1967) 385 F2d 238];
  • the replacement property must be identified within 45 days after transfer of the property sold [Internal Revenue Code §1031(a)(3)(A)];
  • the replacement property must be purchased within 180 days after escrow closes, transferring the property sold [IRC §1031(a)(3)(B)]; and
  • the owner cannot own both properties concurrently if he advances his own funds. [Bezdjian v. Commissioner (9th Cir. 1988) 845 F2d 217]

The receipt of excess proceeds from refinancing or equity financing of the property in preparation for its sale or exchange, or the receipt of net sales proceeds prior to acquiring the replacement property, is cash boot which cannot later be offset. [Revenue Regulations §1.1031(k)-1(f)]

Escrowing the replacement property

The investor opens the purchase escrow on the replacement property as the named buyer.

As the buyer, the investor approves or disapproves all of the buyer’s contingencies in the purchase escrow. Contingencies include preliminary title reports, zoning, new loan commitments, leases and rental operating data, inventories, property inspections, termite reports/clearances, structural conditions and property inspections.

 

The investor will take title to the replacement property directly from the seller of the replacement property.

The investor, on fulfilling all other obligations of the purchase agreement and escrow, then instructs the §1031 trustee to deposit the funds in escrow when it becomes time to close.

However, the investor cannot first receive the net proceeds himself and then deposit them into the purchase escrow, which is called actual receipt. [Carlton, supra]

For the investor to avoid actual or constructive receipt of the net sales proceeds, the proceeds must be received by the escrow opened for the investor’s purchase of the replacement property from either the escrow for the property sold or the buyer’s trustee.

Once the net sales proceeds are deposited to the investor’s account in the escrow for purchase of the replacement property, constructive receipt is still avoided since the funds cannot be released until the seller of the replacement property approves their release or the escrow is closed.

The buyer’s trustee may fund all of the purchase or improvement costs of the replacement property out of the impounded net sales proceeds from the property sold by the investor. These disbursements should be made through the purchase escrow on the replacement property being improved.

If additional funds are required beyond the amount held by the trustee, the investor can advance them as part of the purchase price – again through escrow.

The investor will take title to the replacement property directly from the seller of the replacement property. It is unnecessary for the buyer’s trustee or a transfer facilitator to hold title or any interest in the replacement property, at any time. [Alderson v. Commissioner (9th Cir. 1963) 317 F2d 790; Revenue Ruling 90-34]

The policy of title insurance on the replacement property will always be in the name of the investor, as will the assumption of any loans.

The §1031 trustee will not take title and accordingly will not need a title policy or a second escrow – the trustee’s only task is to fund the purchase. The trustee has no need to act as a strawman to take title and further convey the replacement property to the investor.

Refinance of the replacement property

When the transaction calls for the investor to refinance the replacement property, as in a cash-to-new-loan purchase or exchange agreement, the trust deed for the new loan obtained by the investor is recorded concurrently with the deed conveying the replacement property.

The net proceeds of the new loan are entered on the Recap Sheet as cash paid to acquire the replacement property. These proceeds are from a purchase money loan, called cash boot, not from the assumption of an existing loan, called mortgage boot. [See Form 354 §1.9]

The borrowing of cash under the new financing originated by the investor is in itself an accounting wash since a note is given in exchange for cash borrowed and used to purchase the replacement property.

Thus, the borrowing, being merely the source of the capital invested, is not entered on the Recap Sheet at §1.4 or §1.10.

However, the disbursement of borrowed funds to purchase the replacement property is a cash investment since it is a contribution to the basis in the property acquired. [See Form 354 §5.2]

Impounded funds remaining

Receipt of the unused funds from the sales proceeds is reported as a cash item in the §1031 transaction.

 Should the funds held by the trustee not be entirely disbursed on completion of the §1031 transaction, the trustee, after deducting his fee, will deliver the remaining impounded funds, as well as any interest accrued, directly to the investor.Receipt of the unused funds from the sales proceeds is reported as a cash item in the §1031 transaction. To avoid actual receipt, funds may not be withdrawn before acquiring a replacement property. [Rev. Regs. §1.1031(k)-1(f)]

Interest received by the investor which has accrued on the sales proceeds held by the §1031 trustee is separately reported as the investor’s portfolio/investment category income during the year the interest accrues. [Starker, supra]

Any sales proceeds remaining after closing the purchase of the replacement property are first offset by any carryback note or cash items (boats/airplanes/trust deeds) executed or given by the owner to purchase the replacement property. No tax is incurred on the cash withdrawn and offset by the amount of a carryback note or the value of personal property, and the basis in the property sold (along with profit on that sale) is carried forward to the replacement property without reduction.