This article addresses the proper method for conveying properties in a two-step §1031 transaction.

The normal method of conveyancing

An owner of real estate held for investment or for productive use in a trade or business retains a real estate broker to sell the property.

The proceeds from the sale will be used to purchase replacement property. The owner intends to avoid profit reporting on the sale by completing a two-step §1031 transaction.

The broker locates a buyer who wants immediate possession and ownership of the property. However, the owner has not yet begun the search for suitable replacement property and wants closing to be contingent on his purchase of other property. The buyer agrees to cooperate with the owner to complete the §1031 transaction.

The owner and the broker consider a delayed §1031 reinvestment plan consisting of two separate transactions:

  • the sale of one property; and
  • the later purchase of a replacement property.

Prior to closing the sale, the efforts of the owner and the broker to locate and contract for suitable replacement real estate have not paid off. The owner agrees to complete the sale of his property to the buyer by waiving the contingency for his purchase of other property.

The owner and the buyer now enter into a §1031 agreement, naming a buyer’s trustee to receive and hold the sales proceeds until escrow can be closed on replacement property located and purchased by the owner. [See Form 172-2]

A §1031 trustee, also called a buyer’s trustee, is chosen by the owner to act on behalf of the buyer under a trust agreement.

The §1031 trustee will receive and hold the sales proceeds in a trust account until instructed by the owner to fund the owner’s purchase of a replacement property. The purchase will complete the buyer’s performance of his promise to cooperate in a §1031 transaction.

The §1031 trustee has no responsibilities other than to:

  • hold the net sales proceeds on behalf of the buyer so the owner will avoid actual and constructive receipt of the funds; and
  • disburse the funds to the purchase escrow for the replacement property on the owner’s instructions.

On closing of the sales escrow for the owner’s property, the owner conveys the property directly to the buyer by grant deed. The net sales proceeds are disbursed by escrow directly to the §1031 trustee, not to the owner.

The owner’s closing statement from escrow notes he has received Exchange Valuation Credits (EVCs), in lieu of funds, in a dollar amount equal to the net proceeds handed to the §1031 trustee.

The sales proceeds are disbursed to the §1031 trustee under mutual instructions handed to the sales escrow by the owner and buyer. [See Form 172-2]

The trustee deposits the funds into an interest-bearing trust account as instructed in the trust agreement.

Within 45 days after closing the sale, the owner locates and identifies replacement property by entering into a purchase agreement.

The owner clears all contingencies on completion of his due diligence investigation, including confirming the property’s physical condition, operating data and title conditions.

The owner then calls for funding from the §1031 trustee.

On funding, the purchase escrow closes. The owner receives title directly from the seller of the replacement property on the close of escrow, within 180 days after closing escrow on the property the owner sold.

Was the broker correct in suggesting the delayed §1031 transaction be structured so the owner would directly acquire title to the replacement property by a deed from the seller?

Yes! Neither the buyer of the property sold by the owner nor anyone on the buyer’s behalf was required to take and further convey title, or hold any interest in the replacement property before the owner assumed ownership of the replacement property. [Alderson v. Commissioner (9th Cir. 1963) 317 F2d 790]

Thus, the owner may take title directly from the seller of the replacement property to complete a §1031 transaction, delayed or not. [Revenue Ruling 90-34; W.D. Haden Co. v. Commissioner (5th Cir. 1948) 165 F2d 588]

In a properly structured §1031 transaction, the owner sells his like-kind property, does not receive the sales proceeds and assumes ownership of timely-identified, like-kind replacement property within 180 days of closing the sale. [Internal Revenue Code §1031(a)(3)(B)]

Avoid constructive receipt

Many two-step §1031 transactions, also called delayed exchanges, are structured upon the faulty notion that title to the replacement property must pass through the buyer of the property sold, or through an accommodator/facilitator, in a series of conveyances before title can be acquired by the owner. [Biggs v. Commissioner (5th Cir. 1980) 632 F2d 1171]

Often, escrow companies and accommodators/facilitators insist on the use of a strawman accommodator to take title to the property sold and/or the replacement property on the mistaken belief that title cannot be directly deeded to the ultimate owner.

However, the method of conveyancing used for the owner to transfer the property sold or acquire the replacement property, whether directly from the seller or indirectly through a strawman accommodator, is irrelevant.

The owner’s tax concerns in a §1031 transaction are to avoid actual and constructive receipt of the proceeds from the property he sells, and to meet the 45-day identification and 180-day closing deadlines for the replacement property he acquires.

Actual vs. constructive receipt

To ensure a sale of like-kind property will qualify for §1031 treatment, the owner must avoid receiving the net proceeds from the sale of his property. [Carlton v. United States (5th Cir. 1967) 385 F2d 238]

Receipt of the sales proceeds can be actual or constructive receipt.

Actual receipt occurs when, on closing of the sales escrow, the owner actually receives the net sales proceeds in the form of a check, carryback note and trust deed, assignment of a note and trust deed, or bill of sale for personal property, in exchange for selling his property.

Constructive receipt occurs when the net sales proceeds, although not actually reduced to the owner’s possession, are available to the owner on demand, or for the owner to draw on at any time after the closing of escrow on the property sold.

Including a provision in the trustee’s instructions stating the owner will receive the net sales proceeds from the trust account should the owner fail to locate or purchase a replacement property in satisfaction of the 45-day identification rule or 180-day purchase rule does not constitute constructive receipt of the proceeds. [Alderson, supra]

Titles need not be exchanged

Like-kind property includes real estate held for:

  • productive use in a trade or business; or
  • investment. [IRC §1031(a)(1)]

Investments include all income-producing real estate, classified as rentals, ground leases with over 30 years remaining, and land or vacation homes held for profit on resale.

Profit received on the sale of like-kind property (price minus basis equals profit) is not taxed if the property is then exchanged for like-kind property. [IRC §§1001; 1031(a)(1)]

The profit reporting exemption for an exchange of like-kind property does not require a direct exchange of equities or titles between two owners, where one owner, in exchange for conveying his property, barters for and receives title to a like-kind replacement property deeded directly to him by the other owner. [Biggs, supra]

The profit reporting exemption on an exchange for like-kind property merely requires the seller to assume ownership of a like-kind replacement property, in lieu of receiving cash from the property sold and disbursing it himself to purchase the replacement property. [Carlton, supra]

The conveyance of ownership on acquisition of the replacement property may be delayed by as many as 180 days after closing escrow on the property sold. [IRC §1031(a)(3)(B)]

Another restriction applied to any §1031 transaction bars the owner from concurrently holding title to both the property to be sold and the replacement property, such as when the owner advances funds to purchase and take title to the replacement property prior to closing escrow and conveying the property he sold. [Bezdjian v. Commissioner (9th Cir. 1988) 845 F2d 217]

To avoid this concurrent ownership, a warehousing agent must be used to acquire and hold ownership of the replacement property until the property owned has been sold.

Sequential deeding chaos

Now consider an owner whose net proceeds from the sale of property are disbursed by escrow to an accommodator under mutual instructions to escrow from the owner and his buyer. [See Form 172-3]

The accommodator, following a risky practice, does not agree to and does not place the funds in a trust account since he wants to avoid a trustee’s liability for an accounting and proper use of the funds.

When the owner locates replacement property, the accommodator makes the offer to purchase the property. The offer is accepted and escrow is opened in the name of the accommodator.

The accommodator, rather than the owner, clears all contingencies in the agreement to purchase the replacement property.

The replacement property is deeded to the accommodator on closing of the purchase escrow.

The accommodator opens and closes a second escrow between himself and the owner, and conveys the replacement property to the owner (the actual buyer of the property).

The owner then executes a carryback note and trust deed to the seller of the replacement property to adjust for the larger equity in the replacement property. Any excess cash remaining with the accommodator is released to the owner.

Editor’s note — The owner needs to execute the note and trust deed to offset profit reporting of any cash he receives from the impounded funds (other than the interest).

Although the owner has successfully avoided constructive receipt of the sales proceeds, and the profit on the sale of his property is exempt from profit taxes, the sequential deeding of title is not required. Sequential deeding generates unnecessary activities and fees, and results in an unnecessary risk of loss.

For example, excess fees are paid for the accommodator to take title and for escrow to further convey the property to the owner – a double escrow resulting from the accommodator’s strawman purchase.

If the real estate is located in a county or city that levies a transfer tax on every recording, sequential deeding results in an unnecessary double tax.

Also, the accommodator is in the property’s chain of title and risks liability under any future claims arising against prior owners for hazardous waste or property defects.

More important, the owner’s claims against the seller of the replacement property are weakened, if not invalid, for failure of privity of contract. The accommodator broke the chain.

Also, claims may arise on the carryback note asserting it was recourse paper, not purchase money paper, since the buyer of the property from the seller – the accommodator – did not execute the note and trust deed (the owner did), or an accommodator was used instead of the seller to receive the note and trust deed.

However, a seller of replacement property cannot avoid the anti-deficiency rules applied to carryback notes and trust deeds by claiming the accommodator was the purchaser since he was not the actual buyer. [Ziegler v. Barnes (1988) 200 CA3d 224]

Substance over form

The method or sequence of conveying title does not determine the transaction’s compliance with the §1031 profit reporting exemption; even land sales contracts and lease-option sales are acceptable conveyances for a §1031 transaction, and title is not even transferred.

For instance, equitable ownership of property sold on a land sales contract is transferred to the buyer when the buyer takes possession. The transaction thus qualifies as an immediate sale beginning the 180-day replacement period in which to complete a §1031 reinvestment plan.

Also, if the replacement property is purchased by entering into a land sales contract, the transaction qualifies as completing a §1031 reinvestment plan. The fact that legal title is not conveyed until later when the balance of the purchase price is  paid does not mean the owner has not assumed all ownership responsibilities of the property. An equitable conversion of ownership has occurred, leaving title to the property with the seller as security for the balance owed the seller on the purchase price.

Likewise, it is unnecessary for either the owner’s buyer or the buyer’s trustee (the accommodator) to take title to the replacement property, or hold any other interest prior to the property’s conveyance to the owner. [Barker v. Commissioner (1980) 74 TC 555; Rev. Rul. 90-34]

The economic substance of the completed §1031 transaction, not the manner in which it is structured, determines whether the transaction qualifies for the §1031 profit reporting exemption. [Gregory v. Helvering (1935) 293 US 465]

In addition, direct deeding is less costly, much more efficient and assures proper handling of the transaction. The confusion of deeding sequentially and the attendant, unnecessary documentation is eliminated, as is the agency complication of the strawman accommodator.

The only legitimate purpose a buyer’s trustee serves is to receive and hold the net proceeds from the property sold so the owner avoids actual and constructive receipt of the sales proceeds.

The funds are disbursed by the §1031 trustee when the owner is ready to fund the purchase of the replacement property, which is then deeded directly to the owner.