Understanding the G(6) Restrictions
In essence, a deferred or “delayed” 1031 exchange is simply the insulating of a given taxpayer from receipt of funds. Though a lot of other things may occur, this is the key thing which underlies everything else. This is the essential function of qualified intermediaries and third-party facilitators. Of course, an intermediary may offer counsel or provide information on certain things, such as the relative complexity or risk of a given transaction. But, the primary function of the intermediary is to insulate the taxpayer from constructive or actual receipt of exchange proceeds. If a taxpayer receives exchange funds in an improper fashion, then the exchange may fail. If a taxpayer closes on his or her property without first establishing a facilitator, then that closing will constitute a taxable event.
The so-called G(6) restrictions provide rules for receipt of funds during the course of an exchange. These restrictions are in the section (k) Treasury Regulations which apply to delayed exchanges. As a rule, a taxpayer may not receive funds within the 180 day “exchange period,” but this rule may be suspended. In this post, we will go over the conditions spelled out by the G(6) restrictions. As we will see, there are just a few conditions under which funds may be received. One of these conditions is particularly difficult to qualify for. Let’s go over each of these restrictions in turn.
Agreements Must Limit the Ability to Receive Funds
To create a delayed exchange, a contractual relationship must first exist between the taxpayer and facilitator. The contract must limit the taxpayer’s ability to receive funds in compliance with the G(6) restrictions. This means that the taxpayer cannot have any right to receive funds prior to the end of the exchange period. The only exceptions to this right lie in the three conditions spelled out in paragraph G(6). Below, you’ll find brief descriptions of these three conditions.
A 1031 transaction is meant to be an “exchange.” Cash should be absent from the transaction. The traditional exception to this is the “boot” which occasionally transfers to the taxpayer. However, boot is only transferred to the taxpayer at the end of the exchange period. And so even boot is disbursed in such a way as to not disrupt the underlying concept of the transaction.
First Condition: No Replacement Property Identified
In an earlier post, we discussed the three “identification rules” to identify replacement property. A transaction may be collapsed if it does not comply with one of these three rules. As we know, a taxpayer has a maximum of 45 days to identify replacement property according to these rules.
But what happens if a taxpayer fails to identify anything at all? Suppose a taxpayer is unable to locate any suitable replacement property during the identification period. What then? Well, under G(6)(ii), this is the first condition under which funds may be received within 180 days. If the taxpayer cannot identify any property, then the proceeds may be transferred on the 46th day. This makes intuitive sense. That’s because the taxpayer will be unable to acquire any replacement property if none is identified. This is true even though, technically, there would still be 135 days remaining in the actual exchange period.
Second Condition: All Replacement Property Identified
The next condition is just as intuitive as this first one. Suppose a taxpayer identifies property under one of the three identification rules in a satisfactory manner. And then further suppose that this taxpayer acquires all of the identified property before the end of the exchange period. Under G(6)(iii)(A), in this scenario, the taxpayer may receive the excess funds or boot even though the exchange period hasn’t ended. Again, this is intuitive: the exchange period may not be over, but the taxpayer cannot legally acquire any additional property. The taxpayer may only acquire identified property. If all identified property is acquired, then the exchange is functionally complete. The taxpayer may receive the funds in such a scenario without causing the exchange to collapse.
Third Condition: Occurrence of a Material Contingency
The third condition is not nearly as intuitive as the first and second. Under G(6)(iii)(B)(1)-(3), the taxpayer may receive funds after the 45 day period if a material contingency occurs. The contingency must be accounted for in writing and must relate to the exchange. What’s more, the contingency must be beyond the control of the taxpayer and any disqualified person. However, this condition does not apply to any contingency beyond the control of the replacement property seller. The IRS construes this exception very narrowly, and so taxpayers must be aware of this fact. If a taxpayer attempts to invoke this condition, he or she may be challenged by the IRS.
As these restrictions show, the conditions under which a taxpayer may receive funds are not likely to occur often. This is by design. Taxpayers are usually only able to acquire funds at the end of the exchange period. However, depending on the situation, they may be able to receive all or part of the funds before that time.
Our New York City Tax Attorneys Can Help
At Mackay, Caswell & Callahan, P.C., we’ve studied the regulations pertaining to Section 1031 thoroughly for the benefit of our clients. The regulations which govern exchanges are complex. Accordingly, we highly recommend professional counsel. Taxpayers contemplating an exchange should consider us for their counsel. If you need assistance, please reach out to one of our top New York City tax attorneys today.
Image credit: CreditDebitPro