Greetings,

 

 

In a recent spate of Information Letters to Congressmen and Senators, IRS continues to say that it is contemplating some type of relief for taxpayers who have not been able to timely complete a like-kind exchange because they used a qualified intermediary (QI) that went bankrupt.

 
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 which is held either for productive use in a trade or business or for investment. ( Code Sec. 1031 ) Under Code Sec. 1031(a)(3), property received by the taxpayer in the exchange (the replacement property) must be received by the earlier of 180 days after the date on which the taxpayer transfers the property relinquished in the exchange (the relinquished property), or the due date (determined with regard to extensions) of the taxpayer's federal income tax return for the year in which the transfer of the relinquished property occurs. The regs allow a taxpayer to use a QI to facilitate a like-kind exchange. ( Reg. § 1.1031(k)-1(g)(4) ).

When a taxpayer uses a QI, generally he will (at least in form) transfer the relinquished property to the QI, who will sell the property to a buyer. The QI will then take the proceeds of the sale of the relinquished property, buy the replacement property, and transfer the replacement property to the taxpayer. If the taxpayer receives the replacement property within the period in Code Sec. 1031(a)(3) and meets the other Code Sec. 1031 requirements, he is considered to have engaged in a like-kind exchange of property with the QI and he won't recognize gain on the exchange.

 
Bankrupt QIs. In 2008, several QIs filed for bankruptcy.  Most notably was LandAmerica, which was part of a large public company.  It had approximately 450 exchanges pending and was holding about $420 million in exchange funds. Apparently, LandAmerica had invested exchange funds in "auction rate" securities and could not meet its obligations.  In 2008, constituents of Rep. Doug Lamborn (R-CO) disposed of relinquished property through a QI, who was to sell the relinquished property for cash and use it to acquire like-kind replacement property, which the QI would transfer to the constituents within the statutory Code Sec. 1031(a)(3) exchange period. However, before completing the exchange, the QI became insolvent and filed for bankruptcy. As a result of this failure, the constituents won't receive the replacement property and will likely receive only some of the cash from the sale of the relinquished property at the conclusion of the bankruptcy proceedings. The constituents wanted to know if they were expected to pay capital gains taxes on gains realized on a disposition of property intended to be part of a deferred like-kind exchange.

 
In its response to Rep. Lamborn, IRS said that where a QI fails to acquire the replacement property and transfer it to the taxpayer within the statutory replacement period, a taxpayer can't defer recognition of gain on transfer of the relinquished property under Code Sec. 1031. The taxpayer must currently recognize and report in income any gain realized on the disposition of the relinquished property through the QI.

 
IRS also said that if a taxpayer sustains a loss during the tax year that is not compensated for by insurance or otherwise, he can deduct the loss from gross income under Code Sec. 165(a). These losses generally include losses incurred in a trade or business, losses incurred in any transaction entered into for profit, and losses from theft. If the facts and circumstances surrounding the constituents' transaction show that they sustained a loss due to the QI's actions, they may be able to deduct the loss from gross income, but only in the year the loss is sustained. Under Reg. § 1.165-1(d), a loss is sustained in the year that it is evidenced by closed and completed transactions and fixed by identifiable events occurring in that tax year.

 
IRS sent a substantially similar Information Letter to Sen. Christopher Dodd (D-CT). It also sent a separate set of identical Information Letters recently to Sen. Dodd, Sen. Joseph Lieberman (I-CT), and Rep. John Larson (D-CT), saying it was sympathetic to the plight of property owners left in a deferred-exchange bind due to the bankruptcy of their QIs. IRS said that given "current economic conditions, we are considering the tax policy implications of current law and evaluating the scope of our authority in this area to issue administrative guidance."

 
Conclusion.  This news is, of course, applicable only to exchangers who were victims of QI failures.  It is a reminder, however, that exchangers need to know their QI and/or take other necessary measures to protect exchange funds.  Whatever the IRS ultimately does, it will only affect tax treatment.  The IRS can do nothing to help recover the lost money.