When it comes to 1031 exchanges, the details really matter, because skipping over something important could cost you the benefits associated with a proper 1031. This is why it’s important to do everything by the books from start to finish. It not only gives you peace of mind but gives you the protection that all your bases have been covered when you exchange property. One of these key details is selecting a qualified intermediary.
A question that some individuals researching 1031 exchanges have has to do with whether proceeds from a 1031 exchange may be held in an escrow account with their title company instead of using a qualified intermediary. The main problem with this approach has to do with the concept of constructive receipt. Constructive receipt refers to any situation where you, as the exchanger, have direct control over the funds. In order to reap the benefits of a 1031 exchange, you want to avoid any and all occurrences of constructive receipt.
If the IRS determines that you have control over the 1031 exchange funds at any point during the transaction, they can rule that your exchange was truly a sale, exposing you to capital gains tax. Using the Safe Harbor rule, however, gives you the protection of using an outside party to qualify for the advantages of a 1031 exchange. Safe Harbor refers to a disinterested third party who serves as the holder of the funds. This individual is equipped to act on your behalf with your direction, but he or she has complete control over the funds. In 1031 exchanges, your Safe Harbor individual is your qualified intermediary. If you try to circumvent this, you may end up having to pay capital gains tax. Since this is the primary reason that people seek out a 1031 exchange to begin with, don’t risk losing your benefits by thinking it’s okay to use another entity to manage the exchange. Follow the rules precisely.
When funds are held within a Safe Harbor, you’re not eligible to transfer them to a separate escrow account even if your intentions to put forth an earnest money deposit seem food. The funds used in this kind of transaction can only be used for the purchase transaction. It’s a much safer approach to put forth your own funds as an earnest money deposit and then take them back from the closing company once the transaction is complete. In this case, it’s better safe than sorry.