Installment Sale Reporting of Deferred Exchange Boot

IRC §453 provides that an “installment sale” is a disposition of property where at least one payment is to be received in the taxable year following the year of disposition. Income from an installment sale is taken into account under the “installment method,” whereby income recognized in any taxable year following a disposition equals a proportion of the payments received, that proportion being equal to the gross profit over the total contract price.

IRC §453(f)(6)(C) provides that for purposes of the installment method, the receipt of qualifying property in a like-kind exchange is not considered to be “payment.” However, a problem arises in connection with exchange funds held by a qualified intermediary (QI) in deferred exchanges. Although the eventual receipt of qualifying like kind property is not considered “payment,” the IRS has suggested that exchange funds held by a qualified intermediary at the beginning of the exchange period could be considered as “payment” under Temp. Regs. § 15A.453-1(b)(3)(i). If this were the case, funds held by the QI would render installment reporting of boot gain impossible, even though most of the exchange funds were actually used to purchase qualifying like kind property within the 180-day exchange period.

Fortunately, the final regulations under IRC § 453 provide that the deferred exchange safe harbor regulations under IRC §1031 themselves — rather than the rules proposed in Temp. Regs. §15A.453-1(b)(3)(i) — control in determining whether the taxpayer is in receipt of “payment” at the beginning of the exchange period. Since the raison d’être of the deferred exchange regulations under Section 1031 is to insulate the taxpayer from being considered in constructive receipt of exchange funds, this rule would appear to bless installment reporting of boot gain later attributable to exchange funds held by a qualified intermediary not used to purchase replacement property.

However, one important condition must be satisfied for this “override” rule to apply: The taxpayer must possess a “bona fide intent” to enter into a deferred exchange at the beginning of the exchange period. Regs. §1.1031(k)-1(k)(2)(iv) state that a taxpayer possesses a bona fide intent to engage in an exchange only if it reasonable to believe at the beginning of the exchange period that like kind replacement property will be acquired before the end of the exchange period. If the intent requirement is met, gain recognized from a deferred exchange structured under one or more of the safe harbors will qualify for installment method reporting (provided the other requirements of Sections 453 are met.) The rationale for this rule appears to be that without the bona fide intent requirement, a taxpayer without a true intention to consummate a like kind exchange could engage the services of a qualified intermediary, not acquire replacement property within the exchange period, yet defer gain recognition until the following year under the installment method.

To illustrate the operation of this rule:

On November 1st, 2008, QI, pursuant to an exchange agreement with New York taxpayer (who has a bona fide intent to enter into a like kind exchange) transfers the Golden Gate Bridge to cash buyer for $100 billion. The taxpayer’s adjusted basis in the bridge is $75 billion. The exchange agreement provides that taxpayer has no right to receive, pledge, borrow or otherwise obtain the benefits of the cash being held by QI until the earlier of the date the replacement property is delivered to the taxpayer or the end of the exchange period. On January 1st, 2009, QI transfers replacement property, the Throgs Neck Bridge, worth $50 billion, and $50 billion in cash to the taxpayer. The taxpayer recognizes gain to the extent of $25 billion.  However, the taxpayer is treated as having received payment on January 1st, 2009, rather than on November 1st, 2008. If the other requirements of Sections 453 and 453A are satisfied, the taxpayer may report the gain realized in 2008 under the installment method.

[Note: If the QI had failed to acquire replacement property by the end of the exchange period, and had distributed $100 billion in cash to taxpayer on May 1st, 2009, Regs. §1.1031(k)-1(j)(2)(iv) would still permit gain to be reported on the installment method, since the taxpayer had a bona fide intent at the beginning of the exchange period to effectuate a like kind exchange. Note also: Under its “clawback” rule, California will continue to track the deferred gain on the exchange involving the Golden Gate Bridge. If the taxpayer later disposes of Throgs Neck Bridge in a taxable sale, California will impose tax on the initial deferred exchange. This will result in the taxpayer paying both New York (6.85 percent) and California (9.3 percent) income tax, in addition to New York City (3.65 percent) and federal income tax (15-25 percent, depending on the extent of unrecaptured Section 1250 gain) on the later sale.]

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