Bankrupt or Insolvent Qualified Intermediaries
Deferred exchanges frequently are arranged using a third party QI. Because IRC Sec. 1031 does not provide for an extension of the statutorily mandated period to complete a like-kind exchange, a problem has been created because QIs have filed for bankruptcy, jeopardizing the like-kind exchanges they were handling for clients. Rev. Proc. 2010-14 provides a safe harbor method of reporting gain or loss for certain taxpayers who initiate deferred like-kind exchanges, but fail to complete the exchange because a QI defaults on its obligation to acquire and transfer replacement property to the taxpayer.
Rev. Proc. 2010-14 generally provides that a taxpayer recognizes gain on the disposition of relinquished property only as required under the safe harbor gross profit ratio method described therein. A qualifying taxpayer may report gain realized on the disposition of the relinquished property as the taxpayer receives payments attributable to the relinquished property using the safe harbor gross profit ratio method. Under this method, the portion of any payment attributable to the relinquished property that is recognized as gain is determined by multiplying the payment by a fraction, the numerator of which is the taxpayer’s gross profit and the denominator of which is the taxpayer’s contract price. Any required depreciation recapture is taken into account in accordance with IRC Secs. 1245 and 1250, except that the recapture income is included in income in the tax year in which gain is recognized to the extent of the gain recognized in that tax year.
The following definitions apply solely for purposes of the safe harbor gross profit ratio method:
a. Payment Attributable to the Relinquished Property. This is a payment of proceeds, damages, or other amounts attributable to the disposition of the relinquished property (other than selling expenses), whether paid by the QI, the bankruptcy or receivership estate of the QI, the QI’s insurer or bonding company, or any other person. The amount of satisfied indebtedness (any mortgage or encumbrance on the relinquished property assumed or taken subject to by the buyer or satisfied in connection with the transfer) in excess of the adjusted basis of the relinquished property is treated as a payment attributable to the relinquished property in the year in which the indebtedness is satisfied.
b. Gross Profit. This is the selling price of the relinquished property, minus the taxpayer’s adjusted basis (increased by any selling expenses not paid by the QI using proceeds from the sale of the relinquished property).
c. Selling Price. The selling price is generally the amount realized on the sale of the relinquished property, without reduction for selling expenses. However, a special provision applies if a court order, confirmed bankruptcy plan, or written notice from the trustee or receiver, issued by the end of the first tax year in which the taxpayer receives a payment attributable to the relinquished property, specifies an amount to be received by the taxpayer in full satisfaction of the taxpayer’s claim. In such cases, the selling price is the sum of the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) received or to be received, and the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.
d. Contract Price. This is the selling price minus the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.
The total gain (including recapture income) recognized under the safe harbor should not exceed the sum of (a) the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) and (b) the satisfied indebtedness not in excess of basis, minus the adjusted basis of the relinquished property. Adjustments to the gain determined using the safe harbor gross profit ratio method should be made in the last tax year in which the taxpayer receives a payment attributable to the relinquished property.
Under the safe harbor, a taxpayer may claim a Section 165 loss deduction for the amount, if any, by which the adjusted basis of the relinquished property exceeds the sum of (a) the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) plus (b) the amount of any satisfied indebtedness not in excess of basis. A taxpayer who may claim this loss deduction may also claim a loss for the amount of any gain recognized under the safe harbor in a prior tax year. The timing for claiming any loss is determined under the general rules of IRC Sec. 165, and the character of any loss is determined under the normal capital gain rules (IRC Secs. 1201-1298).
For purposes of applying the safe harbor gross profit ratio method , the selling price, the contract price, and any payment attributable to the relinquished property must be reduced by the amount of any imputed interest allocable to the payment as determined under IRC Sec. 483 or 1274. For purposes of applying the imputed interest rules, the taxpayer is treated as selling the relinquished property on the date the bankruptcy plan or other court order that resolves the taxpayer’s claim against the QI is confirmed (the “safe harbor sale date”). (See section 709 for a full discussion of OID and the safe harbor.) As a result, if the only payment in full satisfaction of the taxpayer’s claim is received by the taxpayer within six months after the safe harbor sale date, no interest is imputed. The selling price determined under the safe harbor rules (see paragraph 714.69) is used to determine whether IRC Sec. 483 (in general, sales for $250,000 or less) or IRC Sec. 1274 (in general, sales for more than $250,000) applies to a transaction.
If exchange funds held by the QI were treated as an exchange facilitator loan (see paragraph 714.83), and the loan otherwise met the requirements of Reg. 1.7872-5(b)(16) (the amount of the exchange treated as loaned did not exceed $2 million and the duration of the loan was six months or less), the IRS will continue to treat the loan as meeting the requirements of Reg. 1.7872-5(b)(16) until the safe harbor sale date, even if the duration of the loan exceeds six months solely due to the QI default. In addition, if an exchange facilitator loan exceeds $2 million, the IRS will not impute additional interest on the loan after the date of the QI default. However, interest may be imputed under IRC Sec. 483 or 1274, as previously described.
Example : Deferring gain under the safe harbor for QI bankruptcies.
Clancy is an individual who uses the cash method of accounting and files federal income tax returns using a calendar year. Clancy owns a 10-acre parcel of land in Peoria as an investment. The parcel’s FMV is $150,000 and its adjusted basis is $50,000. Clancy enters into an agreement with a QI, Quincy Investments (Quincy) to facilitate a deferred like-kind exchange. On May 6, Year 1, Clancy transfers the Peoria property to Quincy, and Quincy transfers it to a third party in exchange for $150,000 cash. Clancy intends that the $150,000 held by Quincy be used to acquire Clancy’s replacement property. On June 1, Year 1, Clancy identifies a 5-acre tract of land in Urbana as replacement property. On June 15, Year 1, Quincy notifies Clancy that it has filed for bankruptcy protection and cannot acquire replacement property. Consequently, Clancy fails to acquire the Urbana property or any other replacement property within the exchange period.
As of the end of Year 1, Quincy’s bankruptcy proceedings are ongoing and Clancy has received none of the $150,000 proceeds from Quincy or any other source. On July 1, Year 2, Quincy exits from bankruptcy, and the bankruptcy court approves the trustee’s final report, which shows that Clancy will be paid, in August of Year 3, $130,000 in full satisfaction of Quincy’s obligation under the exchange agreement. Clancy receives the $130,000 payment on August 1, Year 3, and does not receive any other payment attributable to the relinquished property. Assume that the selling price of the Peoria property is less than $250,000 and that, based on IRC Sec. 483, $5,000 of the $130,000 payment is unstated interest.
Clancy falls within the scope of Rev. Proc. 2010-14 and may report the failed like-kind exchange due to Quincy’s default under the safe harbor rules. He is not required to recognize gain in Year 1 or Year 2 because he did not receive any payments attributable to the relinquished property in those years. IRC Sec. 483 applies to Clancy’s payment in Year 3 because it was due more than six months after the safe harbor sale date, and he received the payment more than one year after that date. Consequently, Clancy’s selling price is $125,000 ($130,000 minus the $5,000 of unstated interest). His contract price is also $125,000 because there is no assumed or satisfied indebtedness. Clancy’s gross profit is $75,000 [the selling price ($125,000) minus the adjusted basis ($50,000)]. His gross profit ratio is 75/125 (the gross profit over the contract price). Clancy must recognize gain in Year 3 of $75,000 [the payment attributable to the relinquished property ($125,000) multiplied by his gross profit ratio (75/125)]. In addition, he must include $5,000 of the $130,000 payment as interest income in Year 3. Even though the payment attributable to the relinquished property ($125,000) is less than the $150,000 proceeds received by the Quincy, Clancy is not entitled to a loss deduction under IRC Sec. 165 because this payment exceeds his adjusted basis in the relinquished property ($50,000).
Planning Tip: Taxpayers planning to use a deferred like-kind exchange may want to consider using a permitted security device, such as a standby letter of credit, qualified escrow, or qualified trust, which affords a measure of safety when using a QI [Regs. 1.1031(k)-1(g)(2) and (g)(3)].