This note provides summary guidance to a lender whose customer is engaged in an Internal Revenue Code Section 1031 like-kind exchange, when the lender desires to take a security interest in cash proceeds from the sale of the customer’s relinquished property, pending reinvestment of those proceeds in new replacement property.
In order for a taxpayer (the lender’s customer) to do a valid like-kind exchange, net proceeds from the sale, after payment of closing costs and mortgage debt, are deposited into an “exchange account” with a Code Section 1031 “Qualified Intermediary.” If the customer takes the funds from closing or uses it to settle other debts, the like-kind exchange may be wholly or partially invalidated. Lenders often seek to take hold of the exchange proceeds, usually in circumstances in which the old property collateralized other debt (such as other mortgage loans). So it will often occur to the lender to request a pledge of the funds in the exchange account. Under the terms of the qualified intermediary arrangement, however, the customer must have no right to receive, pledge, borrow or otherwise obtain the benefits of funds in the exchange account. In order to avoid the exchange from failing, the funds can only be used to acquire qualifying replacement property and cannot be used to secure other debts of the customer. This would leave the lender without recourse to the funds in the exchange account. Furthermore, a Qualified Intermediary acting within the strictures imposed by Treas. Reg 1.1031 (k)-1(g)(6), will only release exchange proceeds directly to the escrow or settlement agent handling the replacement property closing during the 180-day exchange period.
(g)6) Restrictions Explained
In 1991 the U.S. Department of the Treasury established under IRC Section 1031 of the tax code that in order for an exchange to be valid under the safe harbor guidelines, the taxpayer (exchanger) cannot receive, pledge, borrow, or otherwise obtain the benefits of the exchange proceeds before the end of the 180-day exchange period. The IRS has given further guidance providing that use of exchange proceeds for expenses unrelated to the direct purchase of the exchanged properties can create significant issues. In addition to creating taxable boot, it can be deemed to be receipt of exchange funds (or a benefit therefrom) in violation of Treas. Reg. 1.1031 (k)-1(g)(6), causing the exchange to fail.