1031 Exchange Services

I Can't Finish My 1031 Exchange.  Can I Have My Funds Now?

1031 Exchange transactions are always started with the intention of acquiring one or more like-kind replacement properties so that the investor can defer the payment of his or her depreciation recapture taxes and capital gain taxes.  However, 1031 Exchange transactions can and do fail every so often.

What happens if something does in fact go wrong with your 1031 Exchange transaction?  Perhaps you are not able to locate and identify any suitable like-kind replacement properties.  Perhaps you are unable to acquire any of the like-kind replacement properties that you identified.  Maybe you simply decide not to go through with your 1031 Exchange transaction.

Background Information

Section 1.1031 of the Department of the Treasury Regulations provides a number of Safe Harbor provisions or guidelines.  The Internal Revenue Service ("IRS") will not challenge or disqualify a 1031 Exchange transaction as long as the investor has followed the Safe Harbor provisions or guidelines provided for in the Treasury Regulations. 

The most common Safe Harbor provision is the use of a 1031 Exchange Qualified Intermediary pursuant to Section 1.1031(k)-(1)(g)(4)) of the Department of the Treasury Regulations.  Most 1031 Exchange transactions today are structured and completed through a 1031 Exchange Qualified Intermediary.

The 1031 Exchange Agreement sets forth the terms and conditions under which the 1031 Exchange transaction is structured. The 1031 Exchange Agreement must provide that the Qualified Intermediary acquire the relinquished property from the investor and transfer this relinquished property to a third party buyer, and also acquire one or more replacement properties from third party sellers and transfer these replacement properties to you, the investor.

The 1031 Exchange Agreement must also specifically limit the investor's rights to receive, pledge, borrow or otherwise obtain the benefits of the relinquished property sale proceeds prior to the expiration of the exchange period. This restriction on use of funds is comprehensive and is often called the "(g)(6) limitations." See Treas. Reg. 1.1031(k)-(1)(g)(6). The (g)(6) limitations must remain in effect throughout the entire exchange period.

The 1031 Exchange period begins on the date that the benefits and burdens of ownership of the relinquished property is transferred (generally the closing date) and ends on the date of the earliest occurrence of one of the following events:

  1. After the end of the identification period, if the investor has not identified replacement property before the end of the 45-day identification period (i.e., Day 46); or
  2. After investor has received all of the identified replacement properties to which investor is entitled; or
  3. If the investor identifies replacement property, after of the end of the identification period and the occurrence of a material and substantial contingency that: (a) relates to the deferred exchange; (b) is provided for, in writing, and ( c) is beyond the control of the investor and of any disqualified person, other than the person obligated to transfer the replacement property to investor; or
  4. At the end of the 180-day exchange period.

You can elect to structure a 1031 Exchange transaction outside the Qualified Intermediary Safe Harbor provisions, and thereby avoid entering into a written 1031 Exchange Agreement with the mandatory (g)(6) limitation language.  But, by doing so, the investor will also lose the benefits and the protection afforded by the Safe Harbor, and will risk not only the probability of having his transaction set aside by IRS, but of also facing penalties and interest payments.

An attempted 1031 Exchange transaction that is set aside by IRS as a failed 1031 Exchange will be significantly more expensive to a investor than if that same investor simply sold his relinquished property outright, and paid the capital gains tax. So, for those investors who wisely elect to structure a 1031 Exchange transaction under the Qualified Intermediary Safe Harbor provisions, they also "elect" to comply with the (g)(6) limitations. It is clear, however, that many investors do not fully understand the magnitude of these (g)(6) limitations.

Myths and Misconceptions About the (g)(6) Limitations

Misconception No. 1

Taxpayer can cancel an exchange anytime between Day 1 and Day 45 by simply demanding return of all exchange funds from the Qualified Intermediary.

Reality No. 1

There is absolutely no provision for a investor who has entered into a 1031 Exchange Agreement with a Qualified Intermediary to receive money or other non-qualifying property prior to the end of the 45-day identification period.

In order for a investor to structure a 1031 Exchange transaction and take advantage of the 1991 Safe Harbor which authorizes the use of a Qualified Intermediary, the Safe Harbor requires a written exchange agreement that contains, among other things, specific (g)(6) limitations on investor's ability to receive or control the exchange funds. If a written exchange agreement does not set forth the (g)(6) limitations, the Safe Harbor is not satisfied, and the intermediary is not a "Qualified Intermediary."

A non-Qualified Intermediary could be deemed to be the agent of the investor, and as such, would not be eligible to provide exchange services including holding relinquished property sales proceeds. If the "holding party" is not protected by a Safe Harbor, and is deemed to be the agent of the investor, under agency common law provisions, an agent acts on behalf of its principal (the investor), and as such, it would actually be the investor who was "holding" the relinquished property sales proceeds. If a investor actually receives or controls or even has the right to receive or control the relinquished property sales proceeds, the "sale" does not qualify for 1031 non-recognition treatment, and the attempted exchange fails.

Therefore, if a investor intends to complete a 1031 Exchange, and enters into a written exchange agreement with a Qualified Intermediary, then the written exchange agreement must contain certain restricting language regarding the use and control of all of the exchange proceeds. The mandatory restrictions must be in effect from the time that relinquished property is closed until the exchange period terminates. Taxpayer cannot elect to terminate the exchange period. The exchange period terminates only upon the occurrence of the specified events.

Events that terminate the exchange period are clearly defined by the Treasury regulations and do not include a voluntary election by investor. The earliest termination event is Day 46, if investor has not identified replacement property. Thus, the Treasury regulations make no provision for terminating an exchange agreement before Day 46, and the written exchange agreements of all Qualified Intermediaries mirror this requirement.

Misconception No. 2

Taxpayer has identified 3 properties, and subjectively intended to close on only one of the three properties. Since investor successfully closes on one of the three identified properties on Day 60, and used most of the exchange proceeds for this acquisition, investor can demand the immediate return of the remaining, unused exchange funds.

Realty No. 2

Under the (g)(6) limitations, the exchange period for a investor who has identified replacement property does not terminate until the investor has received all of the identified replacement property to which he is entitled to receive under the written exchange agreement. A investor is entitled to receive all the properties that he identifies. Therefore, if a investor identifies three properties, he is entitled to receive three properties. And, until the remaining two properties are purchased, the exchange period does not terminate. Taxpayer cannot receive money or other non-qualifying property from the Qualified Intermediary, until the exchange period terminates. A investor cannot demand return of the "excess" proceeds until Day 180 or until investor acquires the other two replacement properties. Therefore, a investor who intends to purchase only one of the identified properties should clearly state this intention on the identification by simply adding the phrase "one of the following three properties," or by using the word "or" between the three identified properties. Then, when the investor acquires one of the properties, he has acquired all of the identified replacement properties to which he is entitled. The exchange period is terminated and investor is entitled to receive all "excess" exchange funds at that time.

Misconception No. 3

If investor is unable to purchase the identified replacement property due to an inability to negotiate a contract for the purchase, this investor can demand immediate return of his exchange funds based on a "material and substantial contingency that is beyond the control of the investor."

Reality No. 3

The "material and substantial" contingency exception set forth in the (g)(6) limitation has a very narrow application. First, this terminating event is available only after a investor has identified replacement property and the 45-day identification period has expired. Thus, a investor cannot claim "material and substantial contingency" before day 45. Although not specifically defined, Treasury does set forth several examples of events that would be considered "material and substantial contingencies," such as: the replacement property is destroyed, stolen, seized, requisitioned or condemned, or a determination is made that the regulatory approval necessary for the transfer of replacement property cannot be obtained in time for the replacement property to be transferred to the investor before the end of the exchange period. See Treas. Reg. 1.1031(k)-(1)(g)(8) Example 2. In addition, this material and substantial contingency must: (1) relate to the deferred exchange; (2) be beyond the control of investor and any disqualified person; and (3) be in writing.

While the term "regulatory" is not further defined in the regulations, the majority of scholars deem that regulatory is synonymous to governmental. What is also well accepted among scholars is that it is the Internal Revenue Service's position that an economically unfeasible event does not satisfy the "material and substantial contingency beyond the control of investor" requirement. If a investor decides that the asking price of an identified replacement property is too high, or if the identified replacement property is no longer on the market, the Internal Revenue Service has taken the position that such events are not beyond the control of investor who theoretically could acquire the property (albeit at an economically undesirable price) or could force the sale of the identified replacement property by an otherwise reluctant owner by simply offering an excessive price. Economic conditions, or contingencies are deemed not to be "beyond the control of investor," and therefore, do not amount to "material and substantial contingencies" which result in termination of the exchange period. Anything that is within the investor's control, wherein the investor must decide whether to meet a seller's demands, or walk away from an unacceptable business deal, does not amount to a "material and substantial contingency," under the (g)(6) limitation.

Misconception No. 4

To ensure good customer service, all exchange agreements contain the (g)(6) limitations, but many intermediaries will ignore enforcing these provisions of the exchange agreement.

Realty No. 4

A 1031 Exchange Qualified Intermediary, who is economically reliable and reputable, has an appreciation for compliance with the Safe Harbor requirements. This Qualified Intermediary's written exchange agreement contains mandatory language including (g)(6) limitations, which ensures Safe Harbor compliance. If a Qualified Intermediary routinely amends its written exchange agreement, or fails to follow the specific terms of its written exchange agreement, the Service could make a convincing argument that the Qualified Intermediary's standard "actions" in effect amended the terms of the written exchange agreement, and such agreement, as "amended," fails to contain the mandatory (g)(6) limitations. Therefore, this Qualified Intermediary would not be within the Safe Harbor, and all the exchanges in which this intermediary participated, could be invalid. Reputable Qualified Intermediaries who are in the business of structuring and documenting 1031 transactions have a great appreciation for operating with the clearly stated regulations and guidelines that define the Safe Harbor.

"All other Qualified Intermediaries" do not authorize early termination of 1031 Exchange agreements or return exchange funds to investors simply based on a investor's demand. A Qualified Intermediary can provide excellent customer service by ensuring that its documents and actions comply with Section 1031 of the Internal Revenue Code, and the Treasury Regulations promulgated thereunder.

Investors should be clearly advised of the (g)(6) limitations before entering into an exchange agreement. Many Qualified Intermediaries highlight the specific (g)(6) language in their exchange agreements, and have the investors either initial the language or sign a separate paragraph acknowledging the (g)(6) limitations.


Investors have confidently and successfully structured thousands of 1031 Exchange transactions since the introduction of the Treasury Regulations, including the (g)(6) limitations. It is important for investor's legal advisors to ensure that the Qualified Intermediary's written 1031 Exchange Agreement and related 1031 Exchange documents include language which limits the investor's control over their relinquished property net sales proceeds as required under the (g)(6) limitations. 

These (g)(6) limitations are mandatory and must remain in effect until the 1031 Exchange period has ended or the 1031 Exchange has been completed. Once an investor begins a 1031 Exchange under the Qualified Intermediary Safe Harbor, can not "change" his mind and demand the return of his or her 1031 Exchange proceeds until the 1031 Exchange has been completed.

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