Funding Escrow in a 1031 Exchange - Cash vs. Sales Proceeds

In a 1031 exchange, can the seller use sales proceeds to fund the “escrow” account and still defer all taxes related to the sale, or does the seller need to bring cash to closing to fund the escrow? In this blog, we'll discuss this question through the lens of a client's recent 1031 situation.

Background

First, a little bit of background. In this case, the client had to get cash to the buyer at closing as part of a roof/HVAC concession. For the buyer’s financing reasons, he didn’t want it to come right off the purchase price. The client was hoping to get the cash to the seller as a “commission” expense to him since he was unrepresented. However, the buyer was financing through the SBA, and the SBA required an escrow account. Considering all of this, the client wanted to know if they needed to bring cash to the closing in order to defer the tax, or if they could use the sales proceeds to fund the escrow.

Transactional Expenses in a 1031 Exchange

Funds from the sale of the relinquished property may be used to pay customary transactional expenses including attorneys fees related to the disposition of the relinquished property and the 1031 exchange. However, if you have already paid the attorney the fees you typically may not be reimbursed with exchange funds during the exchange period.

The "G(6) limitations" impose stringent limitations on your ability to receive actually or constructively any proceeds from the relinquished property during the exchange period.

Unused Escrow Funds

If there are unused / unspent exchange funds remaining in the 1031 escrow account after the purchase of the last replacement property (at the end of the exchange period), these un-utilized proceeds may go back to you to reimburse you for expenditures you made for the exchange such as attorneys fees that you already paid.

You may want to discuss this with your CPA or tax advisor because reasonable people can differ in their approach to this topic.

• Start Your Exchange: If you have questions about escrow in a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved

1031 Exchanges & Escrow

It's really sad when we get a call from somebody and they say “I sold my relinquished property two weeks ago and I've just decided to do a 1031 exchange. Can you set me up to do a 1031?”

This call comes in quite frequently, partly because people are ignorant about the requirements of Safe Harbor 1031. They think that they can just keep their money in an escrow account or leave the money with the title company and if they choose to do at 1031 they can set it up after the fact.

Be Prepared

The problem is that in order to do a valid Safe Harbor 1031 you have to have an exchange agreement with a qualified intermediary (or facilitator/accommodator) in place before you dispose of the relinquished property. Furthermore, you have to assign your rights in the purchase agreement with the buyer so that the relinquish property purchase agreement is assigned to the intermediary. The intermediary then directs you to deed that property straight to the buyer.

Notice of Assignment

On top of that you have to give written notice of your assignment to the intermediary to all of the other parties to the purchase agreement (e.g., the buyer of the Relinquished Property). If you don't have all of that in place before the closing occurs on the sale of your relinquished property then you don't have a defensible Safe Harbor 1031. The net result is that closing, when the benefits and burdens of ownership shift to the buyer who has actual or constructive receipt of the money.

Even if you leave your money in an escrow account at the title company, it's still your money. You still have the right to go in and take it out at any time (you have control over the proceeds). The only way to do it under the Safe Harbor regulations is to make sure that you have it set up with a facilitator or intermediary before you go to closing and dispose of that property so that you’re insulated so you don't have actual or constructive receipt of the funds.

• Start Your 1031 Exchange: If you have questions about escrow and 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2016 Copyright Jeffrey R. Peterson All Rights Reserved

How to Keep Your Money Safe In a 1031 Exchange

In a typical delayed 1031 exchange, you assign to your qualified intermediary (or “QI”) the rights to take your money from the sale of your old relinquished property. This makes many taxpayers feel uneasy. Do you really know what happens to your money while your QI is holding it for you? In this article, we will offer some tips for keeping your money safe and your mind at ease during your 1031 exchange.

The Answer is 100% Transparency

100% transparency means complete openness and clear communication in your 1031 exchange agreement. Your QI should agree in writing that:

• Your money will not be mixed or commingled with any other customers funds or with the operating account of the QI;

• Your money will be deposited directly (immediately after closing of the sale) into a separate segregated FDIC insured bank account; and

• Your exchange agreement will state what rate of interest (if any) will be credited to your exchange account.

More Safeguards - Adding a Qualified Escrow Agent

The treasury regulations say that you can use more than one safe harbor in the same 1031 exchange. Most people just use the qualified intermediary safe harbor in Treasury Regulation 1.1031(k)(1(g)(4).

However, a better, safer arrangement can be set up by requiring your qualified intermediary to deposit your 1031 money directly with a qualified escrow agent. Treasury Regulation 1.1031(k)(1(g)(3) sets out another safe harbor for qualified escrow agents.

Your FDIC insured bank can be the depository AND act as your qualified escrow agent. Even better, you can have a special written escrow agreement that states that two signatures are required to withdraw any money from the bank’s qualified escrow account:

1. your qualified intermediary’s signature; and

2. your signature.

Your qualified escrow agent cannot be a disqualified person and the written escrow agreement must incorporate the G(6) limitation that you can not have any right to receive, pledge, borrow or otherwise obtain the benefits of the escrowed money during the exchange period.

• Start Your Exchange: If you have questions about keeping your money safe in a 1031 exchange, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2017 Copyright Jeffrey R. Peterson All Rights Reserved