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Clients ask “What if the 1031 Exchange Fails to Complete?”

Over the past month, three attorneys have asked the same question;   When can the Exchanger receive their funds back when a 1031 Exchange transaction fails to complete properly?  What are the 1031 Exchange disbursement rules?

An incomplete Exchange may occur because the Exchanger fails to timely identify replacement properties or changes their mind after the 45-day Identification Period but has identified properties.  Or some other factor may make it impossible to close on their Identified Property.

The brief answer to the above questions is:  It depends—boy does that sound like the lawyer in me.

More particularly, it depends upon the specific factual pattern and the timing of the exchange.  Treasury Regulation Section 1.1031 (k)-1(g)(6) known as the g-6 regulations cover these issues.
The g-6 regulations state that the  Qualified Intermediary (QI) cannot disburse the funds to the exchanger until:

  1. After the 45-day Identification Time Period has expired and the Exchanger has not identified any replacement property; or
  1. The receipt of all Identified Replacement Property has occurred; or
  1. The 180 day time period for the exchange has expired.

That leads to the next question:  If the exchanger is willing to pay its taxes, why should it matter to the Qualified Intermediary (QI) when it disburses back to the exchanger, the 1031 funds it is holding?

The Answer:  By disbursing contrary to the 1031 Exchange disbursement rules (g-6 regulations), the QI would open itself up to being described as an agent of the exchanger, which would disqualify the QI from participating in possible future 1031’s.   Additionally, IRS might determine that the QI has no desire to follow the g-6 rules and could claim that the QI was an agent for all of its exchangers, thereby possibly jeopardizing all of the exchanges it has handled.

As responsible Qualified Intermediaries, it is our job to try to not expose our clients (exchangers) to possible risks.  For a more thorough review of the subject of 1031 Exchange fails, see the article I wrote a couple of years ago for the Florida Bar and its Real Property, Probate, and Trust Law Section.  If you are an attorney, you should join your State Bar’s Real Property, Probate, and Trust Law Section.  This section is hard working and very informative and replete with information for your success as well as for your clients.