August Comment — Deferred Exchanges Under the Regulations

VIEW IN PDF:  Tax News & Comment — August 2011

[Note: Excerpted from Like Kind Exchanges of Real Estate Under IRC. §1031 (David L. Silverman, 3rd Ed.,1/11).View treatise at nytaxattorney.com]

I.  Overview of Statute

A deferred exchange may be a practical necessity if the cash buyer insists on closing before the taxpayer has identified replacement property. Recognizing the problem, Starker v. U.S., 602 F2d 1341 (9th Cir. 1979) articulated the proposition that simultaneity is not a requirement in a like kind exchange:

[W]e hold that it is still of like kind with ownership for tax purposes when the taxpayer prefers property to cash before and throughout the executory period, and only like kind property is ultimately received.

Responding to the IRS refusal to acquiesce to Starker, evolving case law which permitted nonsimultaneous exchanges was codified by the Tax Reform Act of 1984. As amended,  Section 1031(a)(3)(A) provides that the taxpayer must

identif[y] . . . property to be received in the exchange [within] 45 days after . . . the taxpayer transfers the property relinquished in the exchange.

The Regulations refer to this as the “identification period.” Regs. § 1.1031(k)-1(b)(1)(i). The identification of the replacement property must be evidenced by a written document signed by the taxpayer and hand delivered, mailed, telecopied or otherwise sent before the end of the identification period to (i) the person obligated to transfer the replacement property to the taxpayer (i.e., the qualified intermediary); or (ii) to all persons involved in the exchange (e.g., any parties to the exchange, including an intermediary, an escrow agent, and a title company). Regs § 1.1031(k)-1(c)(2).

The 45-day period is jurisdictional: Failure to identify replacement property within 45 days will preclude exchange treatment. Moreover, contrary to many other time limitation periods provided for in the Internal Revenue Code, the 45-day period is computed without regard to weekends and holidays.

The statute states that the 45-day identification period begins upon the “transfer” of the  relinquished property. Does the identification period therefore begin to run on the closing date? Or when the exchange funds are transferred if that date is not coincident? Can an argument be made that the identification period does not commence until the deed is actually recorded?

Where multiple transfers of relinquished property occur, the 45-day identification period (as well as the 180-day exchange period) begin to run on the date of transfer of the first property. Treas. Reg. § 1.1031(k)-1(b)(2).  The normal identification rules are applicable for multiple property exchanges

Some taxpayers, unable to identify replacement property within 45 days, have attempted to backdate identification documents. This is a serious mistake. The taxpayer in Dobrich v. Com’r, 188 F.3d 512 (9th Cir. 1999) was found liable for civil fraud penalties for backdating identification documents. Dobrich also pled guilty in a companion criminal case to providing false documents to the IRS. If the 45-day identification period poses a problem, the taxpayer should consider delaying the sale of the relinquished property to the cash buyer. If the sale cannot be delayed, the possibility should be explored of leasing the property to the cash buyer until suitable replacement property can be identified.

Section 1031 provides for nonrecognition of losses as well as gains in deferred exchanges. This would appear to preclude the taxpayer from intentionally recognizing losses in some transactions in which loss property is disposed of. Although the IRS would likely be unhappy about the result, it would appear that a taxpayer could deliberately structure an exchange to recognize a loss by deliberately failing to identify replacement property within the 45-day identification period. This result appears correct since the failure to identify replacement property within 45 days appears to preclude the transaction from being within Section 1031.

II.  Identification of

Replacement Property

Replacement property must be unambiguously described in a written document or agreement. Real property is generally unambiguously described by a street address or distinguishable name (e.g., the Empire State Building). Personal property must contain a particular description of the property. For example, a truck generally is unambiguously described by a specific make, model and year.  Regs. § 1.1031(k)-1(b)(1).

Acquisition of replacement property before the end of the identification period will be deemed to satisfy all applicable identification requirements (the “actual purchase rule”). Regs. § 1.1031(k)-1(c)(4)(ii)(A).   However, even if closing is almost certain to occur within the 45-day identification period, formally identifying backup replacement property insures against not closing within the 45-day identification period and failing to meet the statutory requirements for an exchange.

The identification of replacement property must satisfy one of the following four rules (which may not be combined in their application):

1.  Up to three replacement properties may be identified without regard to fair market value. Regs. § 1.1031(k)-1(c)(4)(i)(A).

2.    Any number of properties may be identified provided their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of all relinquished properties as of the date the relinquished properties were transferred. Regs. § 1.1031(k)-1(c)(4)(i)(B).

3.     If more than the permitted number of replacement properties have been identified before the end of the identification period, the taxpayer will be treated as having identified no replacement property. However, a proper identification will be deemed to have been made with respect to (i) any replacement property received before the end of the identification period (whether or not identified); and (ii) any replacement property identified before the end of the identification period and received before the end of the exchange period, provided, the taxpayer receives before the end of the exchange period identified property the fair market value of which is at least 95 percent of the aggregate fair market value of all identified properties. Regs. § 1.1031(k)-1(b)(3)(ii)(A)-(B).

[Comment: In situations where the taxpayer is “trading up” and wishes to acquire replacement property whose fair market value is far in excess of the relinquished property, this rule is useful. While under the 200 percent rule the taxpayer may acquire property whose fair market value is twice that of the relinquished property, under the 95 percent rule, there is no upper limit to the new investment.  While there is also no upper limit to the value of the replacement property using the 3 property rule, substantial diversification may not be possible using that rule.

Although the 95 percent rule possesses distinct advantages, there is also a substantial risk: If the taxpayer does not satisfy the 95 percent rule, then the safe harbor is unavailable. This could result in the disastrous tax result of exchange treatment being lost with respect to all replacement properties. If the 95 percent rule is to be used, the taxpayer must be confident that he will ultimately be successful in closing on 95 percent of all identified properties.  There is little room for error.]

4.     In TAM 200602034, the taxpayer identified numerous properties whose fair market value exceeded 200 percent of the fair market value of the relinquished property. Thus, neither the “3-property rule” nor the “200 percent rule” could be satisfied. In addition, since the value of the replacement properties ultimately acquired was less than 95 percent of the value of all identified replacement properties, the taxpayer failed the “95 percent” rule. Nevertheless, those properties which the taxpayer  acquired within the 45 day identification period satisfied the “actual purchase rule”.  Regs. § 1.1031(k)-1(c)(4)(ii)(A).

An identification may be revoked before the end of the identification period provided such revocation is contained in a written document signed by the taxpayer and delivered to the person to whom the identification was sent. An identification made in a written exchange agreement may be revoked only by an amendment to the agreement.  Regs. § 1.1031(k)-1(c)(6). Oral revocations are invalid.   Regs. § 1.1031(k)-1(c)(7), Example 7, (ii).

Regs. § 1.1031(k)-1(c)(5)(i) provides that minor items of personal property need not be separately identified in a deferred exchange. However, this exception in no way affects the important statutory mandate of Section 1031(a)(1) that only like kind property be exchanged. Therefore, if even a small amount of personal property is transferred or received, the like kind and like class rules apply to determine whether boot is present and if so, to what extent. It may therefore be advantageous for the parties to agree in the contract of sale that any personal property transferred in connection with the real property has negligible value. There also appears to be no reason why that parties could not execute a separate contract for the sale of personal property.

If multiple parcels are relinquished in the exchange, the 45-day period begins to run on the closing of the first relinquished property. The last replacement property must close within 180 days of that date. If compliance with this rule is problematic, it may be possible to fragment the exchange into multiple deferred exchanges.

If exchange proceeds remain, the determination of whether the taxpayer has made “multiple” or “alternative” identifications may be important. If the identification was alternative, compliance with one of the three identification rules may be less difficult. Whether an identification is alternative depends on the taxpayer’s intent.

III.  Acquisition of Replacement Property Within

“Exchange Period”

Section 1031(a)(3)(B) provides that replacement property must be acquired on the earlier of

180 days after the . . . taxpayer transfers the property relinquished in the exchange, or the due date [including extensions] for the transferor’s return for the taxable year in which the transfer of the relinquished property occurs.

Thus, if A relinquishes property on July 1st, 2011, he must identify replacement property by August 14th, 2011, and acquire all replacement property on or before January 1st, 2012, which date is the earlier of (i) January 1st, 2012 (180 days after transferring the relinquished property) and October 15th, 2012, (the due date of the taxpayer’s return, including extensions). This period is termed the “Exchange Period.”  Regs. § 1.1031(k)-1(b)(1)(ii).

The exchange period is also jurisdictional: The taxpayer’s failure to acquire all replacement property within the exchange period will result in a taxable sale rather than a like kind exchange. The upshot of this rule is that (i) if the exchange occurs fewer than 180 days before the due date of the taxpayer’s return without extensions, an extension will be required to extend the exchange period to the full 180-days; and (ii) the exchange period will never be more than 180 days. The exchange period, like the identification period, is calculated without regard to weekends and holidays.

The Ninth Circuit, in Christensen v. Com’r, T.C. Memo 1996-254, aff’d in unpub. opin., 142 F.3d 442 (9th Cir. 1998) held that the phrase “due date (determined with regard to extension)” in Section 1031(a)(3)(B)(i) contemplates an extension that is actually requested. Accordingly, if the taxpayer fails to request an extension (even if one were automatically available) the due date of the taxpayer’s return without regard to extension would be the operative date for purposes of Section 1031(a)(3)(B).

(However, if the due date for the taxpayer’s return without regard to extensions occurs after the 180-day period following the exchange (as in the example above), the point would be moot, since the exchange period can never exceed 180 days.

Replacement property eventually received must be substantially the same as the replacement property earlier identified. While the construction of a fence on previously identified property does not alter the “basic nature or character of real property,” and is considered as the receipt of property that is substantially the same as that identified, the acquisition of a barn and the land on which the barn rests, without the acquisition also of the previously identified two acres of land adjoining the barn, will result in the taxpayer being considered not to have received substantially the same property that was previously identified.   Regs. § 1.1031(k)-1(d), Examples 2 and 3.

Replacement property that is not in existence or that is being produced at the time the property is identified will be considered as properly identified provided the description contains as much detail concerning the construction of the improvements as is possible at the time the identification is made. Moreover, the replacement property to be produced will be considered substantially the same as identified property if variations due to usual or typical production occur. However, if substantial changes are made in the property to be produced, it will not be considered substantially the same as the identified property. Regs. § 1.1031(k)-1(e).

IV.  Actual or Constructive

Receipt Negates Exchange

If the taxpayer actually or constructively receives money or other property in the full amount of the consideration for the relinquished property before the taxpayer actually receives the like kind replacement property, the transaction will constitute a sale and not a deferred exchange. If the taxpayer actually or constructively receives money or other property as part of the consideration for the relinquished property prior to receiving the like kind replacement property, the taxpayer will recognize gain with respect to the nonqualifying property received (to the extent of realized gain).   Regs. § 1.1031(k)-1(f)(2).

For purposes of Section 1031, the determination of whether the taxpayer is in actual or constructive receipt of money or other property is made under general tax rules concerning actual and constructive receipt without regard to the taxpayer’s method of accounting. The taxpayer is in actual receipt when he actually receives money or other property or receives the economic benefit thereof.

Constructive receipt occurs when money or other property is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it. Section 446; Regs. § 1.446-1(c). However, the taxpayer is not in constructive receipt of money or other property if the taxpayer’s control over its receipt is subject to substantial limitations.  Regs. § 1.1031(k)-1(f)(1),(2). Thus, Nixon v. Com’r, T.C. Memo, 1987-318, held that the taxpayer was in constructive receipt of a check payable to taxpayer and not cashed, but later endorsed to a third party in exchange for (intended) replacement property.

V.   Final Regulations

On April 25, 1991, final Regs for deferred exchanges were promulgated. Regs. § 1.1031(k)-1(g). Presumably, the vast majority of deferred exchanges (and all involving qualified intermediaries) must now comply with one of the four safe harbors in the regulations. Sensibly, the regulations also permit simultaneous exchanges to be structured under the qualified intermediary safe harbor. While simultaneous exchanges can also be structured outside of the safe harbors articulated in the deferred exchange regulations, compliance with the qualified intermediary safe harbor avoids issues of constructive receipt and agency. Note that the qualified intermediary safe harbor is the only deferred exchange safe harbor made applicable to simultaneous exchanges.  Regs. §  1.1031(b)-2.

V(a). Security or

 Guarantee Arrangements

The first safe harbor insulates the taxpayer from being in actual or constructive receipt of exchange proceeds where the obligation of the cash buyer to provide funds for replacement property is secured by a mortgage or letter of credit. Specifically, the safe harbor provides that whether the taxpayer is in actual or constructive receipt of money or other property before receipt of replacement property will be made without regard to the fact that the obligation of the taxpayer’s transferee (i.e., the cash buyer) to transfer the replacement property to the taxpayer is or may be secured by (i) a mortgage; (ii) a standby letter of credit (provided the taxpayer may not draw on the letter of credit except upon default by the transferee); or (iii) a guarantee of a third party. Regs. § 1.1031(k)-1(g)(2). Compliance with this safe harbor eliminates concerns that the taxpayer is in constructive receipt of the secured obligations. However, compliance with this safe harbor does not dispel concerns about agency.

V(b).  Qualified Escrow

or Trust Accounts

The second safe harbor addresses situations in which exchange funds are segregated in an escrow or trust account. This safe harbor provides that the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the receipt of replacement property will be made without regard to the fact that the obligation of the taxpayer’s transferee to transfer the replacement property is or may be secured by cash or a cash equivalent, provided the funds are held in a “qualified escrow account” or a “qualified trust account.” Regs. § 1.1031(k)-1(g)(3).  Note that compliance with this safe harbor also dispels concerns about constructive receipt, but also does not dispel concerns about agency. Only the qualified intermediary safe harbor, discussed below, addresses both of these issues.

A qualified escrow (or trust) account is an escrow (or trust) account in which (i) the escrow holder (or trustee) is not the taxpayer or a “disqualified person,” and (ii) the escrow agreement limits the taxpayer’s right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account before the end of the exchange period, or until the occurrence, after the identification period, of certain contingencies beyond the control of the taxpayer. Regs. § 1.1031(k)-1(g)(3)(iii).

The agent of the taxpayer is a disqualified person. For this purpose, a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two year period ending on the date of the transfer of the first of the relinquished properties is treated as an agent of the taxpayer. However, services rendered in furtherance of the like kind exchange itself, or routine financial, title insurance, escrow or trust services are not taken into account.

A person who bears a relationship to the taxpayer described in  Section 267(b) or Section 707(b), (determined by substituting in each section “10 percent” for “50 percent” each place it appears) is a disqualified person.

A person who bears a relationship to the taxpayer’s agent described in either Section 267(b) or Section 707(b), (determined by substituting in each section “10 percent” for “50 percent” each place it appears) is also a disqualified person.

The regulations provide that a person will not be disqualified by reason of its performance of services in connection with the exchange or by reason of its providing “routine financial, title insurance, escrow or trust services for the taxpayer.” Treas. Reg. § 1.1031(k)-1(k). The regulation permits banks and affiliated subsidiaries to act as qualified intermediaries even if the bank or bank affiliate is related to an investment banking or brokerage firm that provided investment services to the taxpayer within two years of the date of the exchange.

V(c).   Qualified Intermediaries

The qualified intermediary (QI) safe harbor is the most useful of the four safe harbors, as it addresses both agency and constructive receipt concerns. This safe harbor provides that (i) a “qualified intermediary” is not considered an agent of the taxpayer for tax purposes, and (ii) the taxpayer is not considered to be in constructive receipt of exchange funds held by the qualified intermediary. For the QI safe harbor to apply, the exchange agreement must expressly limit the taxpayer’s right to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by the QI, until after the exchange period, or until the occurrence, after the identification period, of certain contingencies beyond the control of the taxpayer. Regs. § 1.1031(k)-1(g)(4).

PLR 201030020 corroborated the prevailing view that if all of the safe harbor requirements are satisfied for two safe harbors, both may be utilized in a single exchange. To provide an additional measure of safety to its customer’s exchange funds, bank proposed to hold exchange funds in a qualified trust account pursuant to § 1.1031(k)-1(g)(3)(iii). Bank also proposed to serve as a qualified intermediary pursuant to Regs. § 1.1031(k)-1(g)(4). The ruling concluded that “[t]he fact that Applicant serves in both capacities in the same transaction is not a disqualification of either safe harbor and will not make Applicant a disqualified person.” The Ruling also stated that the bank will not be a “disqualified person” with respect to a customer merely because an entity in the same controlled group performs trustee services for the customer. Finally, the Ruling concluded that a bank merger during the pendency of the exchange would not disqualify it as qualified intermediary for the exchange.

The QI safe harbor bestows upon the transaction the important presumption that the taxpayer is not in constructive receipt of funds held by the QI – regardless of whether the taxpayer would otherwise be in constructive receipt under general principles of tax law. In addition, the QI is not considered the taxpayer’s agent for tax purposes. However, the QI may act as the taxpayer’s agent for other legal purposes, and the exchange agreement may so provide. For example, if the taxpayer is concerned about the possible bankruptcy of the QI, expressly stating that the QI is the taxpayer’s agent for legal purposes would reduce the taxpayer’s exposure. So too, the QI may be concerned with taking legal title to property burdened with possible claims or environmental liabilities.  By stating that the QI is acting merely as the taxpayer’s agent, those concerns of the QI might be adequately addressed.

In a three-party exchange, the cash buyer accommodates the taxpayer by acquiring the replacement property and then exchanging it for the property held by the taxpayer. Since the QI safe harbor imposes the requirement that the QI both acquire and transfer the relinquished property and the replacement property, it appears that this safe harbor cannot be used in a three-party exchange since, in such an exchange, the cash buyer acquires the taxpayer’s property, but does not thereafter transfer it. Therefore, the qualified intermediary safe harbor would appear to always require four parties: i.e., the taxpayer, the QI, a cash buyer and a cash seller.

The final Regulations permit the safe harbor for qualified intermediaries (but only that safe harbor) in simultaneous, as well as deferred, exchanges. Regs. § 1.1031-(k)-1(g)(4)(v).

A qualified intermediary is a person who (i) is not the taxpayer or a “disqualified person” and who (ii) enters into a written agreement (“exchange agreement”) with the taxpayer to (a) acquire the relinquished property from the taxpayer; (b) transfer the relinquished property to a cash buyer; (c) acquire replacement property from a cash seller; and (d) transfer replacement property to the taxpayer.  Regs. § 1.1031(k)-1(g)(iii). A number of companies, often affiliated with banks, act as qualified intermediaries.  If an affiliate of a bank is used as a QI, it may be prudent to require the parent to guarantee the QI’s obligations under the exchange agreement. Qualified intermediaries generally charge a fee (e.g., $1,000), but earn most of their profit on exchange funds invested during the identification and exchange periods. Although the QI might pay the taxpayer one percent interest on exchange funds held during the identification and exchange periods, the QI might earn two percent during those periods, providing the QI with a profit of one percent on the exchange funds held during the identification and exchange periods.

A QI is treated as acquiring and transferring property (i) if the QI itself acquires and transfers legal title; or (ii) if the QI (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than the taxpayer for the transfer of the relinquished property to that person and, pursuant to that agreement, the relinquished property is transferred to that person; or (iii) if the QI (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with the owner of the replacement property for the transfer of that property and, pursuant to that agreement, the replacement property is transferred to the taxpayer.  These rules permit the taxpayer to directly deed the relinquished property to the cash buyer, and also permit the owner of the replacement property to directly deed the replacement property to the taxpayer at the closing. Regs. § 1.1031(k)-1(g)(4)(iv)(A),(B)&(C).This may avoid additional complexity as well as additional transfer tax liability and recording fees.

A QI is treated as entering into an agreement if the rights of a party to the agreement are assigned to the QI and all parties to the agreement are notified in writing of the assignment on or before the date of the relevant property transfer. Therefore, if a taxpayer enters into an agreement for the transfer of the relinquished property and thereafter assigns its rights thereunder to a QI and all parties to the agreement are notified in writing of the assignment on or before the date the relinquished property is transferred, the QI is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the QI is treated as having acquired and transferred the relinquished property. Regs. § 1.1031(k)-1(g)(v).

Regs. § 1.1031(k)-1(g)(3) permit the QI to deposit cash proceeds from the sale of the relinquished property into a separate trust or escrow account, which could protect funds against claims of the QI’s creditors.  The exchange documents must still limit the exchanging party’s right to receive, pledge, borrow or otherwise receive the benefits of the relinquished property sale proceeds prior to the expiration of the exchange period.  Regs. § 1.1031(k)-1(g)(6). These are referred to as the “G-6 Limitations.”

The obligation of the QI may be secured by a standby letter of credit or a third party guarantee. The standby letter of credit must be nonnegotiable and must provide for the payment of proceeds to the escrow to purchase the replacement property, rather than to the taxpayer.

Regs. § 1.1031(k)-1(g)(7) enumerates items which may be paid by the QI without impairing the QI safe harbor, and which will be disregarded in determining whether the taxpayer’s right to receive money or other property has been expressly limited, as required. If an expense qualifies under the Regulations, not only will the QI safe harbor remain intact, but no boot will result.

Money or other property paid to the taxpayer by another party to the exchange will constitute boot, but will not destroy the safe harbor. Treas. Regs. § 1.1031(k)-1(g)(4)(vii). However, the payment to the taxpayer of money or other property from the QI or from another safe harbor arrangement prior to the receipt of all replacement properties to which the taxpayer is entitled under the exchange agreement will destroy the safe harbor.  Regs. § 1.1031(k)-1(g)(6).

Regs. § 1.1031(k)-1(g)(7)(ii) provides that a QI may make disbursements for “[t]ransactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).” Regs. § 1.1031(k)-1(g)(7)(i) provides that the QI may also pay to the seller items which a seller may receive “as a consequence of the disposition of the property and that are not included in the amount realized from the disposition of the property (e.g., prorated rents).”

Payments made by a QI not enumerated in Regs. § 1.1031(k)-1(g)(7) would presumably constitute boot. However, the question arises whether those payments would also destroy the safe harbor. Regs. §1.1031(k)-1(j)(3), Example 4, concludes the taxpayer who has a right to demand up to $30,000 in cash is in constructive receipt of $30,000, and recognizes gain to the extent of $30,000. However, Example 4 neither states nor implies that the exchange no longer qualifies under the safe harbor. Therefore, payment of an expense not enumerated in Regs. § 1.1031(k)-1(g)(7) to a person other than the taxpayer would result in boot, but would likely not destroy the safe harbor. However, any payment from the QI to the taxpayer during the exchange period would destroy the safe harbor.

The ABA Tax Section Report on Open Issues first notes that Revenue Ruling 72-456, and GCM 34895 recognize that transactional expenses typically incurred in connection with an exchange, and not deducted elsewhere on the taxpayer’s return, offset boot. The Report notes that these expenses correspond closely to the list of transactional items found in  Regs. § 1.1031(k)-1(g)(7). The Report concludes that transactional selling expenses paid by a QI should be treated as transactional items under Regs. § 1.1031(k)-1(g)(7) which can be paid by the QI at any time during the exchange period without affecting any of the safe harbors under Regs. §1.1031(k).

V(c)(i).  IRC §468B and

              Deemed Interest

Prior to the enactment of Section 468B, most taxpayers were not reporting as income interest or growth attributable to exchange funds held in escrow by qualified intermediaries, and later retained by the QI as a fee.  Since the fee paid to the QI is an exchange expense that reduces the amount realized, the IRS believed that this amount was inappropriately escaping income taxation. Accordingly, on July 7, 2008, the IRS issued final Regulations under Section 468B(g) and 7872, which addressed the tax treatment of funds held by qualified intermediaries in various safe harbors provided by Treas. Reg. § 1.1031(k)-1(g). Under the final Regulations, exchange funds are, as a general rule, treated as loaned by the taxpayer to the QI, who takes into account all items of income, deduction and credit. The final Regulations apply to transfers of relinquished property made on or after October 8th, 2008. The QI must issue an information return (i.e., Form 1099) to the taxpayer reporting the amount of interest income which the taxpayer earned.  Regs. § 1.468B-6(d).

The exchange agreement should provide for sufficient interest to be paid on funds held by the QI. Interest is sufficient if it at least equal to either the short-term AFR or the 13-week Treasury bill rate. If the exchange agreement fails to provide for sufficient interest, interest will be imputed under Section 7872.

Under Regs. §1.468B, the taxpayer is treated as the owner of funds held by the QI in an escrow account.  The taxpayer is then treated as loaning those funds to the QI. The QI is then  treated as paying interest to the taxpayer on the exchange funds. The taxpayer will then treated as compensating the QI with an amount equal to the deemed interest payment received. The rule forces the taxpayer to capitalize as part of the cost of acquiring property (rather than deduct as a current expense) amounts paid to the QI.

An exception to the rule provides that if exchange funds do not exceed $2 million and the funds are held for six months or less, no interest will be imputed under Section 7872. Another exception provides that if the escrow agreement, trust agreement, or exchange agreement provides that all earnings attributable to the exchange funds are payable to the taxpayer, the exchange funds are not treated as loaned by the taxpayer to the exchange facilitator. In that case, the taxpayer would take into account all items of income, deduction and credit. The “all the earnings” rule applies if (i) the QI holds all of the taxpayer’s exchange funds in a separately identified account; (ii) the earnings credited to the taxpayer’s exchange funds include all earnings on the separately identified account; and (iii) the credited earnings must be paid to the taxpayer (or be used to acquire replacement property).

The safe harbor deferred exchange regulations provide that the taxpayer will not be in constructive receipt of exchange funds for purposes of Section 1031. However, under the Proposed Regulations, an interesting tax dichotomy emerges: Even though the taxpayer is not considered as receiving the exchange funds for purposes of Section 1031, the taxpayer is treated as receiving those funds for other income tax purposes.

For purposes of determining whether earnings attributable to exchange funds are payable to the taxpayer, transactional expenses such as appraisals, title examinations, recording fees and transfer taxes are treated as first paid to the taxpayer and then paid by the taxpayer to the recipient.  A fee paid to the QI qualifies as a transactional expense if (i) the amount of the fee is fixed on or before the date the relinquished property is transferred and (ii) the fee is payable regardless of whether earnings attributable to exchange funds are sufficient to cover the fee. This rule is intended to address the perceived problem of a qualified intermediary “fee” actually being used an interest “surrogate.”

V(d) . Interest and Growth Factors

The fourth safe harbor provides that the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the receipt of replacement property is made without regard to the fact that the taxpayer is or may be entitled to receive any interest or growth factor with respect to the deferred exchange funds. Regs. § 1.1031(k)-1(g)(5).

VI.     Requirements of the

  Exchange Agreement

The exchange agreement itself must expressly limit the taxpayer’s right to pledge, borrow or otherwise obtain the benefits of the cash held in the escrow account before the end of the exchange period. Regs. § 1.1031(k)-1(g)(2)(ii). It is not enough that the limitations exist in an ancillary document, or that they derive from local law. In Hillyer v. Com’r, TC Memo 1996-214, the Tax Court denied exchange treatment and held a taxable sale occurred where the exchange agreement failed to contain restrictions on the taxpayer’s right to constructive receipt of the proceeds pursuant to Regs. § 1.1031(k)-1(g)(6).  Florida Industries Investment Corp. v. Com’r., 252 F.3d 440 (11th Cir. 2001) held that where the qualified intermediary was under the control of the taxpayer, the taxpayer had “effective control” of all escrow funds.

Regs. § 1.1031(k)-1(g)(6) provides several rules which permit the exchange agreement to modify the time when the taxpayer has access to exchange proceeds. If the taxpayer fails to identify any replacement property by the end of the identification period, the exchange agreement may provide that the taxpayer has access to exchange funds after the 45-day identification period. Regs. § 1.1031(k)-1(g)(6)(ii).

If the taxpayer receives all identified property prior to the end of the exchange period, the exchange agreement may provide that the taxpayer has access to exchange funds at that time. Regs. § 1.1031(k)-1(g)(6)(iii)(A).  Therefore, if the taxpayer intends to close on one property, but identifies multiple properties as potential “backup” properties, the taxpayer may have to wait until end of the 180-day exchange period to demand the balance of exchange proceeds held by the QI.

The exchange agreement may provide that if an unexpected contingency identified in the exchange agreement causes the exchange go to awry, the taxpayer may have access to exchange funds prior to the end of the exchange period. Thus, the taxpayer may retain the right to receive money held by the QI following the occurrence, after the identification period, of a material and substantial contingency that (i) relates to the deferred exchange; (ii) is provided for in writing; and (iii) is beyond the control of the taxpayer and any disqualified person. Regs.  § 1.1031(k)-1(g)(6)(iii)(B).

PLR 200027028 held that exchange agreements could be modified to allow for early distribution of cash where taxpayer was unable to reach a contract with the seller of replacement property.

If the taxpayer has closed on all identified replacement property prior to the 46th day, then excess exchange proceeds may be distributed after that time, provided the exchange agreement so permits. If the taxpayer has identified no replacement property before the expiration of the 45-day identification period, then the exchange proceeds may be distributed on the 46th day, provided the exchange agreement so permits. The taxpayer may receive excess proceeds at the end of the exchange period, whether or not the taxpayer has closed on all properties identified in the identification period.

If the taxpayer has identified property during the identification period and that property has not been acquired by the end of the identification period, the exchange funds will frozen with the QI until the 180-day exchange period has expired, or until the taxpayer acquires replacement property. This is true even if the taxpayer decides not to acquire identified replacement property on the 46th day. Therefore, if the taxpayer has identified more than one property, and closes on only one property (either before or after the identification period), the remaining exchange proceeds will be frozen with the QI until after the exchange period has ended.

If the taxpayer has funds remaining in the exchange account following the identification period (if no identification is made) or at the end of the exchange period (if no or replacement property of lower value is acquired), the remaining exchange funds paid to the taxpayer over time may qualify for installment sale treatment.  Special installment sale rules apply during the pendency of a like kind exchange pursuant to Treas. Regs. § 1.1031(k)-1(j)(2). Those rules protect the taxpayer from constructive receipt of the exchange funds during the exchange period. That “protection” terminates at the end of the exchange period.

As insurance against a failed exchange, at the time of the “(g)(6)” event, the QI may give an installment note to the taxpayer and assign the obligation under the note to an unrelated assignment company. The assignment company could use those funds to purchase an annuity from an insurance company to provide a funding source for the installment note. It is unclear whether this transaction would qualify for installment sale treatment. Structures like this are being marketed as a fallback to a failed exchange.

VII. Installment Sale Reporting

   of Deferred Exchanges

To benefit from installment reporting, the taxpayer must avoid the receipt of “payment” in the taxable year of the disposition. Under the installment sale rules, a seller is deemed to receive payment when cash or cash equivalents are placed in escrow to secure payment of the sales price. Temp. Regs. § 15A.453-1(b)(3)(i). The regulations further provide that receipt of an evidence of indebtedness that is secured directly or indirectly by cash or a cash equivalent is treated as the receipt of payment. Accordingly, the IRS has suggested that the exchange funds described in the deferred exchange safe harbor Regulations could be considered as “payment” under Temp. Regs. § 15A.453-1(b)(3)(i).

Fortunately, the safe harbor deferred regulations, rather than Temp. Regs. § 15A.453-1(b)(3)(i), apply in determining whether the taxpayer is in receipt of “payment” at the beginning of the exchange period. Thus, Treas. Reg. § 1.1031(k)-1(j)(2) provides that a transferor is not deemed to have received an installment payment under a qualified escrow account or qualified trust arrangement, nor is the receipt of cash held in an escrow account by a qualified intermediary treated as a payment to the transferor under the rules, provided the following two conditions are met: (i) the taxpayer must have a “bona fide intent” to enter into a deferred exchange at the beginning of the exchange period and (ii) the relinquished property must not constitute “disqualified” property. See Temp. Reg. § 15A.453-1(b)(3)(i). Treas. Reg. § 1.1031(k)-1(k)(2)(iv) states that a taxpayer possesses a bona fide intent to engage in an exchange only if it is 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 and 453A are met). However, the relief from the otherwise operative installment sale regulations ceases upon the earlier of (i) the end of the exchange period or (ii) the time when the taxpayer has an immediate right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or the cash equivalent.  Treas. Reg. § 1.453-1(f)(1)(iii). At that time, the taxpayer will be considered to be in receipt of “payment.” However, if all gain is deferred because the taxpayer has completed a like kind exchange, no gain will be recognized.

To illustrate, assume that on December 1st, 2010, 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 QI holds the $100 billion in escrow, pending identification and ultimate closing on the replacement property by the taxpayer. 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, 2011, 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. The taxpayer is treated as having received payment on January 1st, 2011, rather than on December 1st, 2010. If the other requirements of Sections 453 and 453A are satisfied, the taxpayer may report the gain under the installment method.

If the QI failed to identify replacement property by January 15th, 2011 (the end of the identification period) and distributed $50 billion in cash to taxpayer, under Regs. § 1.1031(k)-1(j)(2)(iv) the taxpayer could still report gain using the installment method, since the taxpayer had a bona fide intent at the beginning of the exchange period to effectuate a like kind exchange. (The same logic would apply if the taxpayer had identified replacement property but had failed to close on the replacement property by May 30th, 2011, the end of the exchange period.)

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 (8.97 percent) and California (9.3 percent) income tax, in addition to New York City (4.45 percent) and federal income tax (15 – 25 percent) on the later sale.

In PLR 200813019, the IRS permitted the taxpayer to correct an inadvertent opt-out of the installment method. The taxpayer had intended to engage in a like kind exchange, but failed to acquire replacement property within 180 days. The taxpayer’s accountant reported had all of the income in year one, even though the failed exchange qualified as an installment sale because the taxpayer had not been in actual or constructive receipt of some of the exchange proceeds until the year following that in which the relinquished property was sold. Treas. Reg. § 15.453-1(d)(4) provides that an election to opt-out of installment sale treatment is generally irrevocable, and that an election may be revoked only with the consent of the IRS. The IRS allowed the taxpayer to revoke the inadvertent opt-out, noting that the opt-out was the result of the accountant’s oversight, rather than hindsight by the taxpayer.

VIII.   Installment Method of

           Reporting Boot Gain

Section 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.” The installment method is defined as a method in which income recognized in any taxable year following a disposition equals that percentage of the payments received which the gross profit bears to the total contract price. Consequently, if a taxpayer sells real estate with a basis of $500,000 for $1 million, 50 percent of payments (i.e., gross profit/total contract price) received would be taxable as gross income. Gain recognized in a like kind exchange may be eligible for installment treatment if the taxpayer otherwise qualifies to use the installment method to report gain.

Section 453(f)(6)(C) provides that for purposes of the installment method, the receipt of qualifying like kind property will not be considered “payment.” However, the Temporary Regulations provide that the term “payment” includes amounts actually or constructively received under an installment obligation. Therefore, the receipt of an installment obligation in a like kind exchange would constitute boot. Prop. Reg. § 1.453-1(f)(1)(iii) provides for the timing of gain upon receipt of an installment obligation received in a like kind exchange. Installment notes (which qualify for installment reporting) received in a like kind exchange would not be taxed as the time of the exchange. Rather, as payments are received on the installment obligation, a portion of each payment would taxed as gain, and a portion would constitute a recovery of basis.

The Regulations generally allocate basis in the transferred property entirely to like kind property received in the exchange where an installment obligation is received. The result is that less basis is allocated to the installment obligation. This is disadvantageous from a tax standpoint, since a greater portion of each payment received under the installment obligation will be subject to current tax.

To illustrate, assume taxpayer exchanges property with a basis of $500,000 and a fair market value of $1 million for like kind exchange property worth $750,000 and an installment obligation of $250,000. The installment note would constitute boot, but would be eligible for reporting under the installment method. Under the Proposed Regulations, the entire $500,000 basis would be allocated to the like kind replacement property received in the exchange. No basis would be allocated to the installment obligation. Consequently, 100 percent of all principal payments made under the note would be taxed as gain to the taxpayer. Had the $500,000 basis instead been permitted to be allocated to the installment obligation and the replacement property in proportion to their fair market values, the note would have attracted a basis of $125,000 (i.e., 1/4 x $500,000). In that case, 50 percent ($125,000/$250,000) of each payment would have been a return of basis, and only 50 percent would have been subject to tax. The remainder of the realized gain would have been deferred until the replacement property was later sold.

IX.     Treatment of Earnest

           Money Deposits

Any deposit held by the taxpayer’s attorney should be assigned (along with all of the taxpayer’s rights in the relinquished property contract) to the QI.  The taxpayer’s attorney could also (i) refund the deposit to the purchaser prior to closing, and request that the purchaser cut a check directly to the QI; (ii) refund the deposit to the purchaser at closing, and increase the purchase price to reflect the refund; or since the attorney is an escrow agent; (iii) or release the deposit to the QI at closing.

If the taxpayer contemplates pursuing a like kind exchange, no deposit should be paid to the taxpayer directly. However, if this is a fait accompli, the taxpayer should remit the funds as soon as possible to the QI or, if no QI has been engaged, to the taxpayer’s attorney. If no deposit has been made before the purchase contract has been assigned to the QI, the deposit should be paid directly to the QI.

If the taxpayer is in contract for the purchase of the replacement property before the QI is engaged, the taxpayer will have made the deposit with his own funds. It would clearly violate the deferred exchange “G-6” limitations if the QI reimburses the taxpayer for the deposit prior to closing from exchange funds. However, the QI could reimburse the taxpayer from the exchange funds at closing. The seller could also refund the deposit to the taxpayer at closing, with the QI providing a replacement check.

The QI may make a deposit for replacement property only after the purchase agreement for the replacement property has been assigned the QI. The escrow instructions should provide that if the taxpayer does not close on the property, or if the contract is terminated for any reason, the deposit will be returned to the QI and not the taxpayer.

X.   Failed Exchanges

Consolidation of qualified intermediaries has raised concerns regarding transfers of QI accounts during exchanges. There continues to be concern with respect to QI insolvencies in the wake of several well-publicized failures. In Nation-Wide Exchange Services, 291 B.R. 131, 91 A.F.T.R.2d (March 31, 2003), the qualified intermediary commingled exchange funds in a brokerage account and sustained significant losses. The Bankruptcy Court found that the failure of Nation-Wide to use segregated accounts effectively converted customer deposits to property of Nation-Wide for purposes of bankruptcy law. All disbursements made by Nation-Wide in the 90 days preceding its bankruptcy were returned to the bankruptcy trustee.

More recently, LandAmerica 1031 Exchange Services Company, Inc., a qualified intermediary, invested exchange funds in auction rate securities that became illiquid in 2008. LandAmerica was unable to sell or borrow against those securities, and was forced to seek bankruptcy protection. Since the exchange proceeds were frozen, clients in the midst of an exchange were unable to complete their exchanges within the exchange period. Consequently, those taxpayers’ contemplated exchanges turned into taxable sales. Since the exchange proceeds were frozen in bankruptcy proceedings, the taxpayers were deprived of the sale proceeds with which to satisfy those tax liabilities. Fortunately, the IRS provided relief in Rev. Proc. 2010-14.

Rev. Proc. 2010-14 provides guidance concerning a failed exchange caused by the collapse or bankruptcy of a QI. In this situation, the taxpayer will be unable to access the funds received by the QI from the relinquished property sale during the pendency of bankruptcy or receivership proceedings. While Rev. Proc. 2010-14 does not rehabilitate the failed exchange, it recognizes that the taxpayer “should not be required to recognize gain from the failed exchange until the taxable year in which the taxpayer receives a payment attributable to the relinquished property.” Accordingly, the taxpayer is put on the installment method of reporting gain, and “need recognize gain on the disposition of the relinquished property only as required under the safe harbor gross profit ratio method.”

The Federation of Exchange Accommodators (FEA) have requested the Federal Trade Commission (FTC) and the IRS to regulate qualified intermediaries. Both have declined. A few states, including Nevada and California, do regulate qualified intermediaries. Under California law, the QI is required to use a qualified escrow or trust, or maintain a fidelity bond or post securities, cash, or a letter of credit in the amount of $1 million.  The QI must also have an errors and omissions insurance policy. Exchange facilitators must meet the prudent investor standard, and cannot commingle exchange funds. A violation of the California law creates a civil cause of action.

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