When Can I Get My Funds Out of a 1031 Exchange?

When Can I Get My Funds Out of a 1031 Exchange?
by David Moore of Equity Advantage

In today’s tight Real Estate market we are seeing more transactions with “boot” or simply not being completed.  It is critical that the investor understand when he or she has the right to receive any remaining Exchange Proceeds…

The Exchangor can withdraw funds only if he does not violate any of the safe-harbor requirements of IRC 1031 (referred to as the G6 requirements) and the payment is pursuant to the written Exchange Agreement. If an Exchangor has the right to withdraw funds, the safe-harbor protection is lost, whether or not funds are actually withdrawn.

Payment can be made only:

• After the Identification Period, if no Replacement Property is identified;
• After receipt of all identified Replacement Property;
• At the end of the Exchange Period; or
• After a major contingency relating to the exchange that is out of the control of the Exchangor (such as destruction of the property, a zoning change, or regulatory approval) that is provided for in the exchange agreement (“Major Contingency Requirement”).

The Major Contingency Requirement can be drafted as part of the exchange agreement and could include the following concepts:

• Potential Replacement Property has been properly identified within the Identification Period;
• The Identification Period has expired;
• A written earnest money agreement has been entered into to purchase each potential identified Replacement Property; and
• With respect to each potential identified Replacement Property, either:
  a. The potential identified Replacement Property has been acquired by the Accommodator, or
  b. There is a material and substantial contingency in the written earnest money agreement to acquire the potential identified Replacement Property that has not been satisfied and that is beyond the control of the Exchangor and any disqualified person as provided for in Treas Reg § 1.1031(k)-1(k).

Examples of Major Contingency Requirements and whether they will or will not work:

Works: Earnest money agreement requires marketable title, and title is not marketable.

Works: Earnest money agreement provides that the property must be capable of being financed, and the bank will not finance it because of environmental problems.

Works: Earnest money agreement provides the property must appraise out at a particular value and it does not.

Works: Earnest money agreement provides that a Phase I environmental assessment indicates the Replacement Property has no environmental problem and the Exchangor does not purchase the property because of the results of the Phase I assessment.

Will not work: The exchange agreement cannot provide the Exchangor has negotiated in good faith with the Seller of the Replacement Property and is usable to reach an agreement for the purchase of the property. Priv Ltr Rul 200027028 (July 21, 2000). See Weller, Early Distribution From 1031 Exchange Accounts Another Look at a Strange New Ruling, 93 J Tax’n 2 (2000).

Will not work: Earnest money agreement provides that a condition to purchasing the Replacement Property is that a Phase I environmental assessment that is satisfactory to the Exchangor in his sole discretion be obtained, and the transaction is terminated because the Exchangor determined to not purchase the Replacement Property because of the results of the environmental assessment. This is a condition in the control of the Exchangor.

Will not work: There is no earnest money on the Replacement Property, and the Exchangor cannot purchase it.

Will not work: The property is sold by the Seller to another buyer. It still could potentially be purchased by the Exchangor.

Will not work: The earnest money agreement provides that the property must pass an inspection or due-diligence review that is satisfactory to the Exchangor. This is a condition in the control of the Exchangor.

Will not work: The earnest money agreement for a $1 million Replacement Property provides that a condition of closing is that the refrigerator in Unit 10 (whose value is $50) be in working order and the property is not purchased because this condition is not satisfied. The condition is not material and substantial.

Source: Oregon State Bar “Structuring 1031 Exchanges”- Ron Shellan