Qualified Intermediaries in the Great Recession and Beyond

JurisdictionUnited States,Federal
Publication year2021
CitationVol. 85 Pg. 264
Connecticut Bar Journal
Volume 85.


Connecticut Bar Journal
Volume 85, No. 3, Pg. 264
September 2011


By Richard W. Brown(fn*)

Generally, when property is sold or exchanged, gain or loss is recognized for income tax purposes. However, when property held for investment or used in a business is exchanged for similar property, no taxable gain is recognized pursuant to the "like-kind exchange" provision, Section 1031, of the Internal Revenue Code ("IRC").(fn1) Instead, taxable gain is deferred until the acquired property is later sold or exchanged.

Attorneys and other tax professionals have long utilized the favorable tax deferral treatment provided under Section 1031 to further the long-term investment objectives of their clients and avoid significant tax liabilities. While the direct tax benefits obtained under Section 1031 are considerable, the like-kind exchange provision facilitates additional objectives for investors and business owners, particularly in the real estate market. For example, a real estate investor with a limited number of highly valuable properties may wish to diversify his or her holdings by investing across several properties. Or, a taxpayer with investment property that requires substantial management may wish to exchange it for property that is self-sustaining and less demanding of the taxpayer's time. Finally, an investor may wish to sell an underperforming asset and obtain property that generates greater income or is more likely to appreciate over time. All of these objectives can be achieved through use of a like-kind exchange, while further avoiding the recognition of any taxable gain.

The favorable treatment afforded under Section 1031 is not easily achieved, however; if a taxpayer exchanges the investment property for money, or property not of a like-kind, the Internal Revenue Service ("IRS") will treat the transaction as a taxable sale and not an exchange. For example, John owns an apartment complex worth $1,000,000 with a basis of $400,000. Janet would like to purchase John's apartment complex but does not own investment property in order to complete an exchange. Hoping to defer any taxable gain, John sells the apartment complex to Janet directing her to place the $1,000,000 in an escrow account restricted to the purchase of replacement property. The following month John identifies suitable replacement property and directs the purchase of the property using the escrow funds. This transaction would not qualify as a like-kind exchange under Section 1031. Although the escrow funds were restricted to the purchase of replacement property, the IRS would still regard John as being in receipt of the funds, resulting in $600,000 of taxable gain. In order to avoid this result, and other potential problems, a taxpayer can utilize the services of a Qualified Intermediary ("QI") to complete the exchange.

Instead of dealing directly with Janet, John would convey his apartment complex to an intermediary, who would then transfer the property to Janet, taking possession of the $1,000,000 in exchange proceeds. The intermediary would then use the proceeds to purchase replacement property. Finally, the intermediary would transfer the replacement property to John completing the exchange and deferring the $600,000 in taxable gain. A qualified intermediary acts as a facilitator in the transaction and holds exchange proceeds until the process is complete, ensuring the taxpayer is not in actual or constructive receipt of money and is in compliance with the general requirements of Section 1031. However, should an intermediary not fulfill its fiduciary obligations in an exchange, the consequences to the taxpayer can be devastating.

This article explores the use of qualified intermediaries in like-kind exchanges under Section 1031 and the increase in intermediary failures occurring over the past few years.

The article will explain the IRS's recent establishment of a taxpayer safe harbor available to individuals engaged in failed like-kind exchanges. Finally, the article addresses efforts made toward regulating qualified intermediaries. To effectively address these topics the article first reviews the evolution of Section 1031 through legislative action, IRS announcements, and associated case law.

I. Background

A. The Starker Trilogy

Generally, under Section 1031 of the Internal Revenue Code no gain or loss is recognized on an exchange of property held for productive use in a trade or business if the exchange is for property of a like-kind.(fn2) This exception to the general rule, that gain or loss must be recognized on the sale or exchange of property,(fn3) has been codified in the IRC for nearly a century. The first iteration of what is now known as Section 1031 can be found in the Revenue Act of 1921 which provided, in part:

[O]n an exchange of property . . . no gain or loss shall be recognized . . . when any such property held for investment, or for productive use in a trade or business . . . is exchanged for property of a like-kind or use . . . (fn4)

Although the non-recognition principles of Section 1031 can be traced as far back as 1921, use of such exchanges was fairly limited until nearly half a century later, when there emerged some creative attempts by taxpayers to structure transactions in a manner that included both delayed and multi-party exchanges. The most influential of these transactions was at the center of a series of related cases that were significant in the development of Section 1031.

In 1967, T.J. Starker, along with his son Bruce and daughter-in-law Elizabeth entered into a land exchange agreement with a paper company called Crown Zellerbach Corporation ("Crown") and a similar agreement with Longview Fibers.(fn5) The agreement with Crown provided that the Starkers would transfer all of their interests in 1,843 acres of timberland property in Oregon to the paper company. In exchange, Crown agreed to provide suitable real property in Washington and Oregon to be chosen at a later date by the Starkers. Crown further agreed to pay the Starkers a "growth factor" equal to six percent of the taxpayer's outstanding balance at the end of each year, with any outstanding balance that remained at the end of the five year period being paid to the Starkers in cash as well. Crown ultimately completed the transfer of three parcels of property to Bruce and Elizabeth Starker in 1967 with no payment of cash ever being made.(fn6) The transfers to T.J. Starker, however, took much longer and were not completed until May of 1969.(fn7) The Starkers believed their arrangement with Crown qualified as a like-kind exchange under Section 1031 and, as a result, did not report any gain from the transaction. The IRS disagreed, and assessed tax deficiencies in the amounts of $35,248.81 against Bruce and Elizabeth and $300,930.31 against T.J. Starker.(fn8)

In the initial litigation, generally referred to as Starker I, the taxpayers challenged the assessed deficiencies, and the issue before the court was whether the transaction, as it related to Bruce and Elizabeth, qualified as a like-kind exchange under Section 1031.(fn9) The government argued that the Starkers received mere promises not real property for their timberland, and as such, there was no exchange as required by Section 1031 because the transfers of land from Crown came at a later time. The Oregon District Court did not find the government's argument persuasive and instead held that the transaction qualified as a like-kind exchange under Section 1031. In doing so, the court stated that if "a taxpayer disposes of all his rights in property for a promise from the transferee to convey like-kind property in the future . . . that transaction is still an exchange solely for properties of a like-kind."(fn10)

In the second litigation, referred to as Starker II, T.J. Starker challenged the IRS' assessed deficiency upon the same grounds raised by his son and daughter-in-law in Starker I.(fn11) However, upon review by the Oregon District Court, the same Judge Solomon that ruled in favor of the taxpayers in Starker I held that the exchange did not qualify under Section 1031.(fn12) In so holding, Judge Solomon stated that his previous decision in favor of the taxpayers was a mistake and to find that the exchange between T.J. Starker and Crown also qualified under Section 1031 would be to sanction a tax avoidance scheme and not carry out the purpose of Section 1031.(fn13)

In the third and final installment of the Starker trilogy, T.J. Starker appealed the decision for review by the Ninth Circuit Court of Appeals.(fn14) In that case, (Starker III), the Court ruled against the government's request to interpret Section 1031 in a narrow fashion and instead held that the provision should be broadly construed.(fn15) In doing so, the Court held that a simultaneous transfer of property is not required in order for a transaction...

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