This article discusses an investor’s avoidance of constructive receipt of proceeds from the sale of his property when converting a cash-out sale into a delayed §1031 reinvestment plan.
Converting a sale to avoid profit reporting
A real estate investor decides to sell property he has held for business or investment purposes, also called like-kind property or §1031 property.
To sell the property, the investor hires a broker to locate a buyer.
On determining that the investor intends to reinvest in other property, the broker makes sure the investor understands the profit on the sale will not be taxed if the purchase of other property is coupled with the sale of his existing property in a §1031 reinvestment plan.
However, the investor has yet to locate suitable replacement property.
Rules for delayed closings
The broker informs the owner that a fully qualified §1031 reinvestment plan can be completed even though a cash-out sale has been agreed to and the replacement property has not been located before escrow closes on the sale, called a delayed exchange by the Internal Revenue Service (IRS). [Starker v. United States (9th Cir. 1979) 602 F2d 1341]
The investor is advised the profit on the sale will be exempt from taxes on a delayed §1031 reinvestment if the investor:
- timely identifies and acquires like-kind replacement property [Revenue Regulations §1.1031(k)-1(b)(2)];
- purchases replacement property with equal or greater debt and equal or greater equity than the debt and equity in the property sold; and
- avoids actual and constructive receipt of the proceeds from the sale of the property. [Rev. Regs. §1.1031(k)-1(f)]
Editor’s note — If the client agrees and enters into a listing employing the broker to locate replacement property, the broker who assists in a §1031 transaction will receive an additional fee for his efforts – one for the property sold and another for the purchase of the replacement property. [See Figure 1]
Excerpt from first tuesday Form 102 — Seller’s Listing Agreement
Should Seller acquire replacement property in a transaction in which Broker negotiates, Seller to further compensate Broker on acquisition of the replacement property based on the fee amount stated in §4.1.
Any interest or other time-delay income earned by the net proceeds during the reinvestment delay may be credited to the investor for disbursement on acquisition of replacement property. [Rev. Regs. §1.1031(k)-1(h)]
However, time restraints are placed on the investor for completing the §1031 reinvestment. After the sale closes, the investor has:
- 45 days to identify a replacement property; and
- 180 days (inclusive of the 45 days) or until the date required to file a tax return to acquire ownership of the replacement property, whichever occurs first. [IRC §1031(a)(3)]
Based on the broker’s advice, the investor decides to couple the sale of his property with the purchase of other property in a §1031 reinvestment plan.
Buyer cooperation on the sale
A cash-out sale by the owner of like-kind real estate is converted into a §1031 transaction when the owner avoids actual and constructive receipt of the cash net proceeds during the period between the closing on the property sold and the purchase of the replacement property.
The broker locates a buyer for the property. Ultimately, the buyer and the owner/investor enter into a purchase agreement calling for the buyer to cooperate with the investor to initiate the investor’s §1031 reinvestment. [See first tuesday Form 150 §11.10]
The cooperation provision in the purchase agreement eliminates any need for the investor to later resort to the safe harbor rules to avoid receipt of his sales proceeds.
Receipt of the net proceeds from the sale of the property is avoided by amending escrow instructions prior to or at the time of closing. Closing instructions will route the cash to the §1031 trustee to be impounded until the purchase escrow for the replacement property is ready to close.
Under the cooperation provision, the buyer commits to entering into escrow and trust instructions needed to divert the net sales proceeds that would otherwise go to the investor on closing, to a §1031 trustee.
The investor selects the person that will be appointed by the buyer as the §1031 trustee.
Any person may be selected by the investor to be the §1031 trustee, except family members and any business controlled by the investor. [Internal Revenue Code §267(b); Rev. Regs. §1.1031(k)-1(k)]
Thus, the cooperation needed from the buyer is limited to establishing an intermediary – a §1031 trustee or “buyer’s trustee” – to fulfill his promise to cooperate in the disbursement of funds to buy the replacement property.
After the sales escrow closes, the buyer no longer participates in the investor’s §1031 transaction.
§1031 trustee’s limited role
Prior to closing the sales escrow, a §1031 trust agreement and amended escrow instructions are submitted for the buyer’s signature.
The trust agreement imposes no obligation on the buyer, only on the §1031 trustee. The trust agreement establishes the role of the §1031 trustee in the transaction. [See first tuesday Form 172-4 accompanying this article]
A trust is created by the buyer so the investor can avoid receipt of the proceeds from his sale.
The trust is created by the buyer so the investor can avoid receipt of the proceeds from his sale, which the investor would otherwise receive and hold during the period of delay between the sale and reinvestment.
The trust document is called the Declaration of Trust and is signed by the buyer and a §1031 trustee chosen by the investor. [See Form 172-4]
All trusts establish the rights and obligations of three positions:
The trustor, the trustee and the beneficiary.
As trustor, the buyer will fund the trust by joining with the investor to instruct escrow to disburse to the §1031 trustee those purchase funds that are due the investor, and which he wishes to reinvest.
The buyer is also the beneficiary since the trust will use the funds to complete the buyer’s promise to cooperate by funding the purchase of the replacement property located and purchased by the investor. The trust is irrevocable.
On closing of the sales escrow, the §1031 trustee will receive the sales proceeds and commence the performance authorized and instructed under the trust agreement.
The trust agreement limits the §1031 trustee‘s activities in the investor’s §1031 reinvestment plan to:
- depositing the net proceeds of the sale in an interest-bearing trust account; and
- disbursing the net sales proceeds on instructions from the investor to fund the purchase of replacement property.
Investor’s receipt of interest accruing
To ensure that the investor does not lose his §1031 exemption, the interest cannot be disbursed to him before he acquires ownership of replacement property.
|While the trust exists, the §1031 trustee is instructed to deposit the trust funds in an interest-bearing account.The interest earned helps defray the costs of establishing and maintaining the trust. Interest in excess of the §1031 trustee’s fees and expenses may, but need not be, applied toward the purchase price of the replacement property.|
The investor is entitled to personally receive the accrued interest on the impounded funds since the interest is the product of the earning power from his equity funds held in trust.
The earnings will be reported as interest income by the investor since the earnings are not part of the net sales proceeds.
However, for the investor to ensure that he avoids receipt of the sales proceeds and total loss of his §1031 exemption, the interest cannot be disbursed to him before he acquires ownership of the replacement property. [Rev. Regs. §1.1031(k)-1(f)]
After the §1031 trustee funds the investor’s purchase of replacement property, the trust automatically terminates. Any remaining funds held by the §1031 trustee are disbursed to the investor. The §1031 trustee no longer participates in the transaction.
The trust agreement also names and appoints a successor §1031 trustee to complete the handling of the funds should the original §1031 trustee die or become unable or unwilling to perform the obligations of holding the sales proceeds and funding the purchase of the replacement property.
§1031 escrow instructions
Prior to the close of the sales escrow, the broker dictates supplemental closing instructions which will be submitted to the investor, buyer and §1031 trustee for their signatures. [See Form 172-2 accompanying this article]
The supplemental escrow instructions in no way alter the buyer’s rights and obligations.
Escrow instructions transferring funds to the §1031 trustee ensure the investor will avoid receipt of the sales proceeds on closing.
They amend prior escrow instructions by directing the escrow officer to disburse to the §1031 trustee the funds that are accruing to the account of the investor, except for prorates and any net sales proceeds withdrawn by the investor.
The closing instructions authorize escrow to:
- disburse the investor’s net sales proceeds, less any withdrawals, to the §1031 trustee on the close of escrow; and
- issue a closing statement noting the investor received Exchange Valuation Credits (EVCs), in lieu of “check herewith,” equal to the amount of the proceeds disbursed by escrow to the §1031 trustee. [See Form 172-2]
The EVCs represent the amount of funds held by the §1031 trustee which are available for the purchase of replacement property by the investor.
Even though disbursement of the net sales proceeds is diverted away from the investor to the §1031 trustee, the investor retains full control over the funds for use in the purchase of replacement property.
Does the investor avoid constructive receipt of the net sales proceeds while retaining control over their use to fund the purchase of replacement property?
Yes! Actual and constructive receipt are avoided. Escrow instructions bar the investor from legal entitlement, at any time, to any funds held by escrow. The investor may receive funds from escrow only if agreed to by the buyer – contrary to the amended escrow instructions. [Calif. Financial Code §17421]
The escrow instructions transferring the funds from the sales escrow to the §1031 trustee ensure the investor will avoid constructive receipt of the sales proceeds on closing. [Rev. Regs. §1.1031(k)-1(f)(2),(3)]
The property sold by the investor is conveyed directly to the buyer by grant deed. Control over title and funds is retained by the investor. The risk of loss due to a conveyance of title to an intermediary under safe harbor rules is fully avoided.
Closing instructions direct escrow to disburse funds to the §1031 trustee to avoid the owner’s actual receipt of the net proceeds.
Funding the replacement property
The investor is now ready to complete the delayed §1031 transaction by calling for funding and acquiring the replacement property of his choice.
When the purchase escrow for the replacement property is ready to close, the funds are handed to escrow by the §1031 trustee.
Once the funds are received by escrow, they will be credited to the investor’s account.
The avoidance of actual and constructive receipt continues during escrow for the replacement property – escrow cannot release the funds held for the investor without instructions from all parties. [Fin C §17421]
To complete the §1031 reinvestment plan, the investor instructs the §1031 trustee to fund the purchase of replacement property contracted for by the investor. [See Form 172-3 accompanying this article]
On funding by the §1031 trustee, the purchase escrow for the replacement property is ready to close. Any funds remaining with the §1031 trustee are disbursed to the investor. The excess funds must be reported as profit. [IRC §1001]
The investor takes title to the replacement property directly from the seller. Thus, the reinvestment plan is completed.