The Importance of the (g)(6) Restrictions in Exchange Agreements – the OTA’s Decision in Kayyem

By: Michael Wiener

If you look closely at your exchange agreements, you will notice references to “Treas. Reg. 1.1031(k)-1(g)(6).”  While this language may seem like simple boilerplate, the failure to include this language can result in a disallowed 1031 exchange, as illustrated by the California Office of Tax Appeals (the “OTA”)[1] recent decision in The Consolidated Appeals of the Kayyem Trust, R. Kayyem and M. Kayyem.[2]

By way of background, the Treasury Regulations governing 1031 exchanges provide that the exchanger cannot receive the proceeds from the sale of its relinquished property (subject to certain exceptions that are not relevant here).  Receipt of the relinquished property sales proceeds (including both actual receipt and constructive receipt) can potentially invalidate the exchanger’s entire exchange.  For this reason, the proceeds from the relinquished property sale are delivered, not to the exchanger, but to a qualified intermediary (a “QI”) that holds these proceeds and uses them to acquire the exchanger’s designated replacement property.  However, as a result of the relationship between most exchangers and their QIs, under general tax principals, the QI may be treated as the exchanger’s agent, in which case any funds received by the QI will be treated as having been received by the Exchanger.

The Treasury Regulations solve for this with a safe harbor.  The safe harbor provides that the QI will not be the exchanger’s agent if the exchange agreement expressly limits the exchanger’s rights to “receive, pledge, borrow, or otherwise obtain the benefits of money or other property” held by the QI as provided in Section 1.1031(k)-1(g)(6).  These restrictions, commonly known as the “(g)(6) restrictions”, provide that the exchanger can only receive money held by the QI in certain very specific circumstances.  that govern deferred 1, such as when the taxpayer does not identify any replacement property before the end of the identification period, or when the taxpayer timely identifies replacement property and acquires all of the identified replacement property.  If an exchange agreement does not expressly contain the (g)(6) restrictions, the exchange will fall outside of the safe harbor and the determination of whether or not the QI is the exchanger’s agent will be made based on general tax principals.

Which brings us to the Kayyem case.  To simplify the facts, the exchanger engaged a QI to sell its relinquished property and acquire its replacement property.  This intermediary, in turn, engaged an escrow company to hold the relinquished property sales proceeds during the course of the exchange.  The exchange agreement did not include the (g)(6) restrictions.  The exchanger sold its relinquished property and timely identified and acquired its replacement property.  On its tax return, the exchanger reported over $14 million of deferred gain. On audit, the California Franchise Tax Board disallowed the exchanger’s entire exchange.

The exchanger conceded both that the exchange agreement did not include the (g)(6) restrictions and that both the QI and the escrow company were acting as the exchanger’s agents.   Still, the exchanger argued that it did not have constructive receipt of the sales proceeds since the QI and escrow company had control of the sales proceeds at all relevant times.  Further, the exchanger never attempted to access the sales proceeds and was unaware at the exchange agreement did not include the (g)(6) restrictions. The OTA rejected these arguments, saying that the lack of a documented legal restriction on the exchanger’s access to the sales proceeds, together with the receipt of the sales proceeds by the exchanger’s agents, resulted in the exchanger having constructive receipt of the sales proceeds.

The Kayyem case serves as a cautionary tale.  The result would have been different had the exchange agreement (and any agreement with the escrow company) contained the (g)(6) restrictions.

[1] The OTA was created in 2017 and has replaced the Board of Equalization as the body that hears appeals regarding taxes administered by the California Franchise Tax Board.

[2] The decision was issued in December of 2024, but was only published at the start of February 2025.

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