Understanding 1031 Exchanges: What is Constructive Receipt?

During a like-kind exchange, the exchanger cannot take actual or constructive receipt of the sales proceeds. Here’s what these terms actually mean and how to make sure you’re doing things right.

When researching Section 1031 like-kind exchanges, you may come across a lot of terminology that you aren’t familiar with. While these terms may seem arbitrary, the rules for like-kind exchanges are strictly interpreted, and have been refined over more than 100 years of legal precedent. It’s important to understand what these phrases mean in the context of 1031 and why they matter.

In a forward exchange (also called a “deferred exchange”), once you sell your relinquished property, the proceeds from that sale are used to purchase your replacement property. These transactions don’t have to be performed simultaneously; in most situations, you have up to 180 days after the relinquished property sale to acquire your replacement property. During that time, the exchanger must avoid “actual or constructive receipt” of the sales proceeds.

What is actual or constructive receipt? The difference is important, as you must avoid both for your exchange to be successful. Let’s take a closer look at these terms and the steps that must be taken to comply with this provision in tax law.

How the IRS defines actual and constructive receipt

Here’s what Section 1031 of the Internal Revenue Code says regarding the proceeds from the relinquished property sale during a forward exchange:

In the case of a transfer of relinquished property in a deferred exchange, gain or loss may be recognized if the taxpayer actually or constructively receives money or property which does not meet the requirements of section 1031(a) before the taxpayer actually receives like-kind replacement property. If the taxpayer actually or constructively receives money or property which does not meet the requirements of section 1031(a) in the full amount of the consideration for the relinquished property, the transaction will constitute a sale, and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.

What this says is that if you receive any portion of the sales proceeds (in the form of cash or property) before the replacement property is acquired, that portion will be subject to taxation. And if you receive the entire amount before the replacement property acquisition, the exchange is invalidated, resulting in no tax deferral.

The sales proceeds from the relinquished property sale must go toward the replacement property acquisition, not held by you or used for another purpose. Another section outlines the difference between actual and constructive receipt:

The taxpayer is in actual receipt of money or property at the time the taxpayer actually receives the money or property or receives the economic benefit of the money or property. The taxpayer is in constructive receipt of money or property at the time the money or property is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time or so that the taxpayer can draw upon it if notice of intention to draw is given.

There are several important points here. “Actual receipt” refers to when you physically control the sales proceeds, or when you receive “economic benefit.” You can’t be given a check for the sale amount, and you also can’t request that the buyer write the check out to a creditor to pay off an unrelated outstanding debt, because that would constitute receiving economic benefit.

“Constructive receipt” refers to when the money is made available to you, even if you don’t physically have it. Sales proceeds can’t be wired to your account, or to any account where you’re able to withdraw funds. They must be in an account from which you can’t make withdrawals, under the supervision of a third party. So how do you set up an account that you can’t draw upon, and who controls this account?

Constructive receipt: the importance of properly structured accounts

As we’ve noted, the Internal Revenue Code can be complex, and exchangers don’t want to end up with large tax obligations because they accidentally violated rules they thought they understood. More direct guidance is available through “Safe Harbor” rules, which outline procedures that, if properly followed, can all but guarantee adherence to the law.

There are many Safe Harbor rules regarding the handling of exchange funds, but a few of note are those that describe the types of bank accounts where your sales proceeds can be held until they are used for the replacement property acquisition:

In the case of a deferred exchange, the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the taxpayer actually receives like-kind replacement property will be made without regard to the fact that the obligation of the taxpayer’s transferee to transfer the replacement property to the taxpayer is or may be secured by cash or a cash equivalent if the cash or cash equivalent is held in a qualified escrow account or in a qualified trust.

What is a qualified escrow or qualified trust? A qualified escrow is an escrow account that follows specific guidelines, including that “the escrow holder is not the taxpayer or a disqualified person” such as the exchanger’s attorney, and “the escrow agreement expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account.”

Similar rules apply to trust accounts. What’s important to understand is that you and your representatives cannot control this account. It must be set up according to Safe Harbor rules by a third party to ensure that you don’t have unrestricted control of the funds. This third party is known as a Qualified Intermediary (QI), a crucial part of a like-kind exchange.

There are some rules for QIs, such as that the QI cannot be “the taxpayer or a disqualified person” and must enter “into a written agreement with the taxpayer” to establish its role in the exchange. Unfortunately, as JTC’s Justin Amos noted, there’s little else limiting who can be a QI or how QIs must operate: “the Qualified Intermediary industry is still an unregulated industry, so there’s not a set of rules or regulations that each QI needs to follow.”

Technically, any third party that does not fall under the definition of a “disqualified person,” which includes “a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two-year period ending on the date of the transfer of the first of the relinquished properties,” could act as QI. But that doesn’t mean it’s a good idea to ask just anyone; after all, mistakes made by a QI can be costly.

What happens if you take actual or constructive receipt of exchange funds by accident?

It’s important to understand that the IRS isn’t likely to be lenient or understanding if you choose the wrong QI. If you’re found to have taken constructive receipt of funds because of an improperly structured escrow account, the exchange will fail, and “the replacement property received by the taxpayer will be treated as property which is not like kind to the relinquished property.”

One scenario is that you take actual or constructive receipt of funds prior to the acquisition of the replacement property. Realizing that your exchange will be invalid, you decide against acquiring the replacement property so you can use the cash to pay taxes on the relinquished property sale.

Another outcome could be that you don’t realize your exchange is in violation of Safe Harbor rules, and you go ahead and acquire the replacement property. You only find out after the fact, once your tax return has been reviewed by the IRS, that your exchange has been deemed invalid. In this situation, if you’ve already used your full sales proceeds to acquire the replacement property, you may have to sell your newly acquired property to cover the capital gains taxes on the relinquished property sale.

Obviously, those situations are not ideal. To prevent an exchange from being invalidated by the actions of a careless third party, you should never work with a cut-rate QI. Instead, work with a trusted name that knows how to execute a successful exchange.

How to prevent 1031 disaster: finding a QI that understands qualified escrow and trust accounts to avoid constructive receipt

As the law stipulates, in order to perform a 1031 exchange, you need a QI. You also need an exchange agreement prior to your relinquished property sale, and you must avoid actual or constructive receipt of funds. The best way to set yourself up for success is to find a QI that understands Safe Harbor rules and can properly set up an account to hold your sales proceeds.

It’s a bad idea to work with anyone who will try to skirt the rules. The law makes it clear that “this section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.” Thinking you can outsmart the system is a mistake, and you want a QI that will follow the rules to the letter, not bend them.

You also want to be sure your QI is someone you can trust with those funds; if your QI puts the exchange funds into an account where your funds are commingled with other exchangers’ funds (or other business funds), they could be used improperly and not made available when you need them to acquire your replacement property.

JTC has built its reputation by pioneering best practices for Qualified Intermediaries through many years of successful like-kind exchanges. Our team has experience with all kinds of 1031 exchanges and understands how to follow Safe Harbor rules. All exchange funds are held in qualified escrow or qualified trust accounts, never commingled with other funds, and only released with dual authorization by JTC and the exchanger.

JTC also provides full transparency through our Exchange Manager portal, which allows our clients to view the location and status of their funds at any time, 24/7, from anywhere in the world. We provide thorough documentation, including a full audit trail, so when it’s time to prove to the IRS that your exchange was executed properly, you’ll be prepared.

With JTC, you don’t just get a Qualified Intermediary to hold your funds; you get a trusted partner who can help you execute the exchange that’s best for your situation, letting you maximize the benefits of Section 1031, defer taxes, and invest in your future.