Like-kind exchange relief for taxpayers snared by bankrupt qualified intermediaries.

• Author: Bakale, Anthony S.

The IRS has finally provided a safe-harbor method to report gain or loss by taxpayers who are unable to complete a deferred like-kind exchange solely due to a qualified intermediary (QI) who defaults on its obligation to acquire and transfer replacement property. On March 5, 2010, the IRS issued Rev. Proc. 2010-14, which will not treat taxpayers as being in actual or constructive receipt of exchange proceeds if they cannot complete an exchange because of a default of a QI in bankruptcy or receivership.

Many taxpayers use a QI in like-kind transactions, where they will transfer the relinquished property to the QI, who will then sell the property to a buyer. The QI will take the proceeds of the sale of the relinquished property, buy the replacement property, and then transfer the replacement property to the taxpayer. If the taxpayer receives the replacement property within the period required and meets the other Sec. 1031 requirements, he or she is considered to have engaged in a like-kind exchange of property with the QI and will not have to recognize gain on the exchange. But what happens when the QI cannot complete the transaction because the QI files for bankruptcy or is placed in receivership?

The IRS has been promising some type of relief for a long time. As far back as 2007, when the real estate market was starting to have problems, Representative Barney Frank (D-MA) asked the IRS to look into this issue. It was then that the IRS indicated that it was considering whether it was appropriate for it to extend relief where a QI was placed in bankruptcy. In July 2009, in response to a constituent of Representative Doug Lamborn (R-CO) who had a done a like-kind exchange with a subsequent bankrupt QI, the IRS said that where a QI fails to acquire replacement property and transfer it to the taxpayer within the statutory replacement period, a taxpayer cannot defer recognition of gain on the original transfer of the relinquished property under Sec. 1031. Accordingly, the IRS held that the taxpayer must recognize and report in income any gain realized on the disposition of the relinquished property through the QI. It also pointed out that a taxpayer would be entitled to a loss as a result of the QI's actions, but only when that loss is evidenced by a closed and completed transaction under Regs. Sec. 1.165-1(d).

However, the subsequent loss would not help in most cases because it may not be recognized until several years later. Generally, the taxpayer would not be able to recognize loss under Sec. 165 until it received notice of the proceeds it would acquire at the conclusion of the bankruptcy proceedings. But the IRS sent information letters to Senator Christopher Dodd (D-CT) and Representative John Larson (D-CT), saying it was sympathetic to the plight of property owners left in a deferred-exchange hind due to QI bankruptcy. It again stated that it is reviewing the scope of its authority to issue administrative guidance in this area.

Background

In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind that is held either for productive use in a trade or business or for investment (Sec. 1031). Under Sec. 1031(a)(3), for a deferred exchange to be treated as tax free, a taxpayer must identify the replacement property within 45 days of the...