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What Happens When 1031 Exchanges Fail to Complete?

My primary goal as a Qualified Intermediary (QI) is to ensure that our client engages in a successful 1031 exchange, resulting in deferred capital gains taxes, etc.  1031 Exchanges are not successful every single time. So what happens when the transaction hits a glitch? Many times we find ourselves dealing with a client who wants their money back right now! Sometimes, we just can’t make that happen because there are strict 1031 Exchange disbursement rules.

Over 20 years ago (1991), the Treasury Department established safe harbors for effectuating 1031 exchanges. Arguably, the most common of these safe harbors is the use of a Qualified Intermediary (QI).

Under Section 1031 of the Internal Revenue Code, a QI is supposed to acquire the relinquished property from the taxpayer, transfer title to the purchaser of that property and then hold the proceeds from that sale. Once a replacement property has been identified and placed under contract by the taxpayer, the QI will use the funds that it is holding to purchase that property and then it will complete the exchange by transferring that property to the taxpayer. This process is outlined in the requisite Exchange Agreement entered into between the taxpayer and the QI.

Treasury Regulations (g)(6) Limitations

One important requirement outlined in the Exchange Agreement limits the taxpayer’s access to his or her funds throughout the Exchange period and is set out in Treasury Regulations 1.1031(k)-(1)(g)(6), commonly referred to as the “(g)(6) limitations.”  If the Exchange Agreement fails to limit the taxpayers rights to receive, pledge, borrow or otherwise obtain the benefits of the relinquished property sale proceeds prior to the expiration of the exchange period[1], the QI will be deemed to allow the taxpayer access to those funds and may be viewed as an agent of the taxpayer causing the 1031 Exchange to fail and the transaction to be treated as a sale. While no taxpayer wants their exchange to be treated as a taxable sale, many taxpayers become suddenly uncomfortable when they realize they are bound by Section (g)(6). As of today, there is no creative way around these limitations.

Almost every taxpayer that familiarizes themselves with 1031 Exchanges, knows about the 45 day and 180 days rules. The taxpayer has 45 days from the date that the benefits and burdens of ownership in the relinquished property are transferred to identify a replacement property and 180 days from the transfer of the relinquished property to close on the replacement property that they previously identified. However, these rules do not indicate that the exchange period is over in 180 days.  Depending on the taxpayer’s situation, it may be over sooner.

Pursuant to the “(g)(6) limitations,” the exchange period is over when the soonest of the following events occurs:

  • If the taxpayer fails to identify any replacement properties, the exchange period ends on the 46th day after the transfer of the relinquished property[2]; or
  • If the taxpayer has received every property identified during the identification period, the exchange period ends on the day following the acquisition of the last of the identified properties[3]; or
  • If after the identification period, a material, substantial contingency occurs that does not practically allow for acquisition of the replacement property. The contingency must:
    1. Relate to the exchange[4]
    2. Be provided for in writing[5]
    3. Be beyond the Exchanger’s control or the control of a disqualified party other than the QI[6]; or
  • On the 181st day following the transfer of the relinquished property[7].

The limitations set out in (g)(6) are not elective. Nevertheless, a certain amount of confusion and misunderstanding surrounds (g)(6) and its often ill-received restrictions.

Examples of (g)(6) Limitations (1031 Exchange Disbursement Rules)

Tax Folklore #1:  If the taxpayer changes his mind about participating in a 1031 Exchange before the 45 day identification period is over, all he or she has to do is ask the QI for their money back and the funds will be immediately returned.

Tax Truth #1: The Treasury Regulations are clear on the fact that if a taxpayer elects not to identify replacement property, the taxpayer must wait until the 46th day following the transfer of the relinquished property to receive any proceeds from the sale of that property. There is no allowance for a taxpayer who changes their mind to receive their proceeds any sooner.

A 1031 Exchange that is structured with a QI will involve an Exchange Agreement and that Agreement will contain the (g)(6) restrictions. If the Agreement does not contain the language, the QI may be deemed the agent of the taxpayer because the QI is not limiting the taxpayer’s access to the funds from the transfer of the relinquished property.

According to Section 1031, if the Qualified Intermediary is the agent of the taxpayer, the exchange will fail and the transfer will be treated as a taxable sale. The (g)(6) language is in effect for the entire exchange period. Therefore, if a taxpayer changes his mind about participating in a 1031 Exchange before he or she identifies a replacement property, the taxpayer will have to fail to identify a replacement property and will then have to wait until the identification period is over, i.e. the 46th day after the transfer of the relinquished property, to receive any funds from the transfer of that relinquished property.

Tax Folklore #2:  Suppose the taxpayer used the three-property identification rule to identify three properties but decided to purchase only one property and used most of his or her exchange proceeds to do so. If the taxpayer closed on that replacement property on day 80, and is not going to purchase any more of the identified replacement properties, the taxpayer may immediately receive his or her leftover exchange proceeds.

Tax Truth # 2:  The Exchange period is not terminated until the taxpayer has acquired every property identified as replacement property. Therefore, if the taxpayer identified more than one property using any of the identification rules and did not close on all of the identified properties, the taxpayer must wait until the 181st day following the transfer of the relinquished property to receive any of the remaining exchange funds.

The “(g)(6) limitations” are clear on the issue of acquiring identified property and the exchange period is not over until all identified properties have been received by the taxpayer. If a taxpayer identifies three properties but knows that he or she only intends to acquire one of the properties, the taxpayer should state clearly on the identification statement that the taxpayer is identifying three properties but is only purchasing one of the identified properties. In that event, the exchange period terminates when the replacement property is received by the taxpayer and any excess exchange funds may be distributed to the taxpayer immediately thereafter.

Tax Folklore #3:  In the event that the taxpayer has identified a replacement property but for reasons out of his or her control fails to close on that property, the taxpayer may immediately receive the exchange funds and the exchange period terminates because the taxpayer would have purchased the replacement property but for “material and substantial contingency(ies) that are beyond the control of the taxpayer.”

Tax Truth #3:  While there is an exception for material and substantial contingencies under (g)(6), the exception is very narrow and strictly construed. In order to qualify for the exception, the taxpayer must have identified property during the 45 day identification period and the identification period must have already expired eliminating the taxpayer’s ability to revoke his or her identification of the property and/or to identify additional property. Therefore, the taxpayer cannot claim the material and substantial contingencies exception until after the 45 day identification period.

Examples of material and substantial contingencies described by the Treasury Department include a determination that the regulatory approval necessary for the transfer of the replacement property cannot be obtained in time for the taxpayer to receive that property prior to the termination of the exchange period, as well as instances where the replacement property is destroyed, stolen, seized, requisitioned or condemned.

Certain aspects of this narrow exception are either not well-defined or not defined at all by the Treasury Regulations. However, the term “regulatory” is understood to mean governmental. Material and substantial contingencies do not include properties that are on the market for a price that is too high or property that has been taken off the market or sold to another party. The IRS’s position on the issue of material and substantial contingencies with regards to unreasonable asking prices for replacement property has been that the taxpayer is in a position to offer enough money and thus pressure to make the seller sell. Under these circumstances, the decision to offer more money and force a sale is not out of the control of the taxpayer. That type of situation will simply not satisfy the material and substantial contingencies exception under (g)(6).


The 1991 Safe Harbors were created to aid taxpayers and their advisors in structuring 1031 Exchanges with minimal fear of invalidation. The Safe Harbors and Qualified Intermediaries’ compliance with them, particularly “(g)(6) limitations”, have facilitated millions of successful exchanges and the provisions simply cannot be swept aside. The “(g)(6) limitations” are not elective or optional, if a taxpayer wants to take advantage of using a QI to structure a 1031 Exchange, then the “(g)(6) limitations” and 1031 Exchange disbursement rules are something they have to live with. Perhaps, the greatest disservice that a QI can do their clients is to bend these rules and risk harming all of their client’s interests in a seamless Exchange. Reputable and reliable QI’s are wise to inform their clients of the “(g)(6) limitations” and the need for strict compliance – a warning that should go a long way for the client who wants their money yesterday!

This article should not be considered tax, accounting or legal advice.  Readers are urged to seek advice from their accounting or legal professional before taking action.


[1] Reg Section 1.1031(k)-1(g)(6)(i)

[2] Reg. Section 1.1031(k)-1(b)(2)(i)

[3] Reg. Section 1.1031(k)-1(g)(6)(iii)(A)

[4] Reg. Section 1.1031(k)-1(g)(6)(iii)(B)(1)

[5] Reg. Section 1.1031(k)-1(g)(6)(iii)(B)(2)

[6] Reg. Section 1.1031(k)-1(g)(6)(iii)(B)(3)

[7] Reg. Section 1.1031(k)-1(b)(2)(ii)

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