1031 IRS Updates
Rev. Proc. 2010-14 Provides Relief for Taxpayer Reporting Gain Due to Bankrupt Qualified Intermediary
Rev. Proc. 2010-14 provides a safe harbor method for reporting gain or loss for taxpayers who initiate deferred like-kind exchange under IRC §1031 but fails to complete the exchange because the qualified intermediary (QI) defaults on its obligation to transfer replacement property as a result of entering bankruptcy or receivership. Previously, taxpayers who were unable to complete deferred exchanges as a result of QI default were required to recognize gain triggered upon transfer of relinquished property in the tax year in which the transfer occurred. Rev. Proc. 2010-14 provides that when a taxpayer is unable to complete an exchange because the QI entered bankruptcy or receivership, gain is deferred until the tax year net liability relief exceeds basis and/or payments attributable to relinquished property are received as a result of the bankruptcy or receivership proceeding. Rev. Proc. 2010-14 is retroactively effective for like-kind exchanges that fail due to QI default on or after January 1, 2009. It can also be used by taxpayers involved in earlier QI defaults by filing an original or amended return, subject to the limitations on credit or refund under IRC § 6511.
In order to qualify for the safe harbor method for reporting gain under Rev. Proc. 2010-14, taxpayers must meet four conditions:
1. Transfer (or be deemed to transfer) relinquished property to a QI in accordance with § 1.1031(k)-1(g)(4) (the QI safe harbor);
2. Properly identify replacement property within the 45 day identification period (unless the QI default occurs during that period);
3. Fail to complete the like-kind exchange solely due to a QI that becomes subject to a bankruptcy or receivership proceeding; and
4. Do not have actual or constructive receipt of proceeds from sale of relinquished property (other than liability relief) prior to QI’s bankruptcy or receivership proceeding.
Taxpayers meeting these criteria may report gain (including gain as a result of depreciation recapture under IRC §§1245 and 1250) on relinquished property as payments are received based on a gross profit ratio method. The gross profit ratio method allows taxpayers to first apply tax basis to liability relief and then proportionally to cash payments as they are received. Accordingly, if relinquished property was unencumbered or if total debt did not exceed basis, no taxable gain must be recognized until cash payments are received from the bankruptcy or receivership.
For example, taxpayer A has an investment property with a fair market value of $160, an adjusted basis of $90 and which is encumbered by a mortgage of $60. On May 6, Year 1, via a written exchange agreement, A transfers property to QI and QI transfers property to buyer for $160. QI uses $60 of buyer’s proceeds to retire the mortgage and places the remaining $100 in an exchange account. Within 45 days A identifies a single replacement property. Before A can direct QI to acquire replacement property and within 180 days of the initial transfer, QI informs A that it has filed for bankruptcy. As of December 31, Year 1, A has received none of the $100 of exchange funds. On September 1, Year 2, QI exits from bankruptcy. The bankruptcy plan of reorganization specifies that QI will pay A $35 in October of Year 2 and $35 in February of Year 3 (or $70 total of A’s original $100 of exchange funds).
Under Rev. Proc. 2010-14, A would not be required to recognize gain in Year 1 because the $60 of liability relief did not exceed A’s adjusted basis in investment property of $90. A would then be required to recognize $20 of gain ($60 liability relief + $70 from QI = $130 – $90 adjusted basis = $40 total taxable gain) for each $35 payment made in Year 2 and 3. See Rev. Proc. 2010-14, example 2.
Interest may be imputed on payments later received from a QI bankruptcy under §483 or §1274. For purposes of calculating imputed interest the “sale date” is the date of confirmation of the bankruptcy plan or other court order that resolves the taxpayer’s claim against the QI (the “Safe Harbor Sale Date”) not the date of the original transfer of property from taxpayer to QI.
Similarly, if exchange funds held by QI were treated as an exchange facilitator loan under Treas. Reg. §1.468B-6(c)(1) but the loan otherwise met the requirements of §1.7872-5(b)(16) ($2 million or less and with a term six months or less) then the IRS will continue to treat the loan as meeting the requirements of Treas. Reg. §1.7872-5(b)(16) until the Safe Harbor Sale Date even if the duration exceeds six months solely due to QI default. If the loan exceeds $2 million (thereby failing to qualify under Treas. Reg. §1.7872-5(b)(16)) then no additional interest will be imputed under §7872 after the date of QI default. However interest may be imputed under §483 or §1274.
Finally, if the total amount received by taxpayer from QI is less than the original sale price of relinquished property (as may often be the case) then the gross profit ratio is adjusted downward accordingly. Taxpayers may claim a loss deduction under IRC §165 if the amount received from QI plus liability relief does not exceed tax basis of relinquished property transferred.
Provided by the Federation of Exchange Accommodators
