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Constructive Receipt and the Validity of Your 1031 Exchange

Constructive ReceiptAn investor wanting to defer capital gains associated with the sale of business or investment real estate, will plan to take advantage of an IRC Section 1031 exchange of like-kind property.  In the forward-delayed exchange, the most commonly used 1031 exchange, the sale proceeds from the relinquished property must not be received either actually or constructively by the seller (exchanger).  The IRS requires the sale proceeds to go directly to a Qualified Intermediary and remain in escrow there until the replacement property has been purchased.  At closing of the replacement property, the Qualified Intermediary disburses the funds.  This is one of the “safe harbors” the IRS created to enable a taxpayer to avoid actual or constructive receipt.

The IRS “constructive receipt” doctrine of Section 1.1031(k) – 1 (f)(2) that states that a “taxpayer is in constructive receipt of money or property at any time the money or property is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so the taxpayer may draw upon it at any time.”

The mere intent of a taxpayer to sell an investment property and purchase and close on another like-kind property within the prescribed time frames does not meet the IRS requirements of a tax deferred exchange and will result in a taxable sale.  Being deemed to have constructive receipt of the sales proceeds will cause the exchange to fail.

A common mistake made by investors is leaving the proceeds of the sale in the escrow account of a title company handling the sale closing until the investor later instructs the title company to apply those funds to a like-kind purchase.  The IRS invokes the “constructive receipt” doctrine in these cases and requires the tax to be paid along with penalties and interest.

To ensure your sale of and subsequent purchase of like-kind property will be allowable as a 1031 exchange, contacting a Qualified Intermediary prior to the sale of your property is a must.  I have been a Qualified Intermediary for 25 years and can provide the exchange documentation that restricts access to the sale proceeds to ensure your exchange qualifies for tax deferral.

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