Following the rules of a 1031 exchange can be a relatively straightforward process. One of the key regulations of a 1031 exchange is that you, as the exchanger, cannot touch the proceeds from the sale of your property.  You cannot take actual or constructive receipt of your funds. This catches some new exchangers unaware as there are quite a few ways to “touch” the proceeds.

Starting the 1031 exchange in the wrong manner or improper handling of funds or documentation by your qualified intermediary can catch you off guard by inadvertently give you constructive receipt of the proceeds. When this happens, it can completely destroy the tax deferral in an exchange. This, in turn, can subject you to all capital gains tax.

Constructive Receipt – What is it?

What is constructive receipt? What are the differences between it and an actual receipt? Actual receipt happens when the person completing the 1031 exchange directly receives the sale proceeds from the surrendered property. How the funds arrive doesn’t matter, it can be through cash or a wire transfer into an account, for example. However, if the person
completing exchange has direct access to the proceeds at any time, the transaction will no longer qualify as a 1031 exchange.

This brings us to constructive receipt, which is a bit more complex. Constructive receipt happens when the person completing the 1031 exchange has the right to receive the funds or control them in some way. This can occur even if the person does not have direct access to the money.

An example of this would be receiving the proceeds from a sale in the form of a check. Even if the check is never cashed, it is still considered constructive receipt.  This still applies even if the immediate intention is to sign the check over to the qualified intermediary.

Another example is when you use a qualified intermediary who promises contractually to return or transfer your proceeds at any time you ask.  Control in this way is constructive receipt and puts you at risk. Even if you do not have money transferred inappropriately.  Putting it in the exchange agreement gives you control and invalidates the “exchange”.  That intermediary has doomed your exchange before it even starts.

In order to prevent this from happening, it is important that all investors using 1031 exchanges have a qualified  intermediary ready before a sale even takes place. A skilled qualified intermediary will make sure when the relinquished property is sold that no actual or constructive receipt takes place.