Qualified Intermediary - What happens if 1031 doesn't go through?

Question

I'm looking at doing a 1031 exchange on a property that I'm selling on a short notice due to an unexpected offer.

I nervous about finding the "perfect" investment replacement with only a few weeks to identify the property.

From my understanding, a qualified intermediary puts the funds in escrow and then ensures that it's done correctly.

Let's say I go this route and I don't find the a property that I'm interested in during the specified time period. I would imagine that the intermediary would simply cut me the check and then I would pay capital gains on the earnings? Is it easy to access my money if I have an issue going through with the exchange? Would intermediary charge me if the deal doesn't go through? If so, about how much am I looking at?

Bill Exeter · Answer

I wanted to elaborate on Dave's comments above.

Section 1031 of the Internal Revenue Code (1031 Exchange) works in conjunction with Section 453 of the Code (Installment Sale Treatment).

This means that when (or if) your 1031 Exchange fails it is taxable under the installment sale rules because you do not have immediate access to your 1031 Exchange proceeds.  The year in which you will recognize and realize the tax will depend on when you have the right to receive the funds. The Treasury Regulations are very clear that a Qualified Intermediary is not permitted to release the 1031 Exchange funds unless certain events have occurred such as the 45 calendar day identification period passing or the 180 calendar day exchange period passing.

So, in the example above, if you close on the sale of your relinquished property after November 16th, your 45th calendar day identification deadline will fall in the next tax year.  You would not have the right to receive your net proceeds until after the 45th day.  This assumes that your Qualified Intermediary includes the correct language in your exchange agreement and follows the rules.  Your capital gain would therefore be taxable in the following tax year.

Here is my main point of clarification.  Your depreciation recapture can not be deferred under the installment sale rules, so in the example above, your capital gain would be deferred into the following year, but you would pay your depreciation recapture taxes in the year of sale.  You have to be careful and plan your cash flow accordingly so that you can afford to pay the taxes.  You can also elect to take the tax hit in the current year instead of treating it as an installment sale if that turns out to be better for you.

The comment above regarding the Qualified Intermediary that accepts a letter of termination at any time is concerning as they are not following the Treasury Regulations.  I would be very concerned should they get audited as to what the services position would be on that issue if they routinely violate the Treasury Regulations.  Also, they are doing their clients a disservice if they routinely allow that because a failed exchange may not qualify for installment sale treatment if they routinely allow the termination at any point in time.  I would also check their documentation to see if they have included the restrictive language that I mentioned above.

Shawn Davis · Answer

Hi Thomas @John Thedford is right that you should call around.  I use an intermediary that gets nothing unless the 1031 is completed.  Getting my money back is a matter of signing a notice of termination and waiting the 3-5 business days to get my money.

Since you seem new at this I will share a huge mistake I made with my first 1031.  I had held the property for over 14 years so had been depreciating the asset for all that time.  I had both a CPA at the time and the 1031 intermediary and both were aware that I was doing the 1031 but neither pointed out to me that my capital gains for the purpose of the 1031 (and for determining debt to value ratios on your replacement property) will include the obvious capital gains (i.e., you bought the property for $100,000 and sold it for $200,000 so $100,000 capital gain right?) but also you have to add back in the amount that you depreciated as well so if you have held the property a long time like I did this can be quite a bit.  In my case what I thought was a $100,000 gain was in fact (for tax purposes) a $180,000 gain.  Unfortunately, my replacement property was based on the $100,000 gain and the remaining $80,000 was treated by the IRS as if I had received it in cash at the closing of the relinquished property.  Ouch!  The added bummer was that I bought other properties during the time frame for the 1031 and had I understood the above, I would have gladly rolled that recapture amount into a new property.

Another thing to consider if you are worried about the time frame to identify and find the new property is to see if your buyer will work with you to delay closing.  Of course, that has its own risks but if the deal is good and you aren't worried they will close maybe you could put it out an extra 30 days or so to give you a little more time and then start looking immediately.

Finally, I'm sure you know this but the intermediary must be involved before and at the closing on the relinquished property as the proceeds from the sale cannot "flow through" you or your bank accounts for even a nanno-second...

Good Luck!

Dave Foster · Answer

@Thomas  Lam

It's not unusual for a client to start but not finish a 1031 due to not finding a suitable replacement.  As a matter of fact it's very prudent to not let the small exchange fee drive a long term decision like a questionable purchase of a replacement property.

Yes, what you describe is exactly what happens - if you cannot find a suitable replacement property then you receive your money and recognize the taxable gain.  Depending on when it happens during the calendar year can make a big difference on how you pay the tax.  If you have an opportunity coming up this summer try to close after Nov 16 so that your 45th day falls after the first of the year.  If you cannot find a suitable replacement then do not turn in a 45 day identification list.  You will receive the funds after the first of the year so they will show gain recognition in 2016 and you will pay the tax a year later in April of 2017.  You can also do the same thing with the 180 day deadline but the length of time your funds are tied up is problematic for some investors.

@Shawn DavisThat's a most unfortunate story.  One of the most basic of rules regarding 1031 exchanges is the = or up rule.  In order to completely defer all tax you must purchase at least as much as your net sale before mortgage relief.  So many people (and I guess a few QIs) mistakenly think that only profit must be reinvested.

Dave Toelkes · Answer

@Shawn Davis,

Based upon your comments, it seems your understanding of 1031 basics may be flawed.

Just to clarify, let me restate what others have told you in this thread.

There are only two basic rules for a completely tax-deferred 1031 delayed exchange

1.  The purchase price of the replacement property must equal or exceed the net sale price of the relinquished property.  Net sale price is the sale price minus selling expenses.   In other words, the net sale price is the amount of money you would have received at settlement if you owned the property free and clear.

2.  All of your net proceeds from the relinquished property sale must be reinvested in the replacement property.

If you had followed these rules, then your adjusted basis in the old property becomes your initial basis in the new property (meaning unrecaptured depreciation is transferred to the new property).  The minimum replacement property value for a fully tax-deferred exchange is not determined solely by your capital gain due to appreciation plus accumulated depreciation.

Of course, we don't have all the details about how much taxable boot was taken and how that was treated for tax purposes, but there may be tax basis ramifications to discuss with your current CPA.  If you paid unrecaptured depreciation tax on the sale of the replacement property and if your adjusted basis in the relinquished property became the basis in the replacement property, then you should speak to your accountant about increasing your tax basis in the replacement property by the amount of deprecation that was recaptured.

Steve Babiak · Answer

I paid around $900 to the QI a couple of years back. If you don't complete the exchange, I believe the tax bill is basically the same capital gains as if you did not try an exchange. And of course you now have to get the money that the QI is holding (in expection of using it when buying the replacement).

John Thedford · Answer

The few I am familiar with charge under 1K. As far as your time to complete the exchange here is something to consider: if you list your property, set a closing date as far out as reasonably possible once you have it under contract. Those extra weeks will give you more time to find properties and make offers. If you find one you wish to make an offer on, time your closing to occur after yours sells.

Bill Exeter · Answer

Hi @Richard Chang yes, that is correct.  Great to hear from Alhambra!  I was born in San Gabriel and raised in Arcadia through early 20's!  I worked in Glendale and Pasadena for years.  You're in my old stomping ground!

@Chris E. you are most welcome.

Chris E. · Answer

Thanks @Bill Exeter and @Dave Foster, lots of great info in there.

Richard Chang · Answer

Hi,

So, if you had bought the replacement property for $280,000 instead of $200,000 then you would NOT have had a $80,000 BOOT causing by recapturing depreciation. I didn't know this.  Thanks for pointing this out !

:)

Shawn Davis · Answer

@Dave Foster - Well luckily I did understand the most basic rule and purchased the replacement property at more or less the same price as the relinquished property.  I just forgot to figure in the value of depreciation recapture and include it in my gains (So basically, I should have purchased a property that cost significantly more than the relinquished property.). The silver lining is that I won't be making that mistake again, that's for sure!  Live and learn...

Qualified Intermediary - What happens if 1031 doesn't go through?

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