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IRS gives relief for failed exchanges when intermediary becomes bankrupt

The IRS has issued a revenue procedure to help taxpayers left “holding the bag” when exchange intermediaries defaulted on completing exchange transactions relating to a bankruptcy of the intermediary.

In a typical deferred exchange, the proceeds from the sale of property are deposited with a qualified intermediary, which later uses the funds to pay for a replacement property.

Recently some high-profile intermediaries filed for bankruptcy and failed to pay the funds to complete exchange transactions. This is potentially a taxable event, for which the exchanging taxpayer could owe a tax and not have cash to pay it. For example, Edward Okun owned 1031 Tax Group and 16 other exchange intermediary affiliates that owed more than $150 million of exchange funds and filed for bankruptcy. LandAmerica was another exchange intermediary that owed more than $419 million of exchange funds when it filed for bankruptcy.

According to Revenue Procedure 2010-14, the taxpayer will generally report the failed exchange as an installment sale. Income is only reported as cash is received, so cash not yet received because the bankruptcy is in process won’t be taxable until it is paid as a bankruptcy settlement.

The amount of debt for the sold property that was paid off using the sale proceeds and is in excess of the tax basis (cost for determining tax gain or loss) is counted as cash received in the year the debt was paid (usually the year of the sale). For example, if a $60,000 mortgage is paid off from the sales proceeds of land that cost $40,000, $20,000 would be treated as cash received in the year of sale.

If the bankruptcy is completed in the year of sale, the sales price and contract price are reduced for any amounts that won’t be paid. For example, if a property is sold in 2010 for $100,000 cash, deposited with a qualified intermediary and it’s determined by December 31, 2010 that $40,000 is cancelled in bankruptcy, the sales price and contract price will be adjusted to $60,000.

Depreciation recapture income is included in income to the extent of gain recognized in a taxable year based on cash received, and such income is taxable before other (capital) gains.

Unstated interest can still be imputed for a failed exchange, but the taxpayer is treated as selling the relinquished property on a safe harbor date, which is the date the confirmation of the bankruptcy plan or other court order that resolves the taxpayer’s claim against the qualified intermediary. If the payment is made within six months after that date, no interest is required to be imputed.

In some cases, taxpayers may be entitled to claim a loss when the bankruptcy is done and the amount of loss can be determined. The loss would be the total amount of cash received (including cash used to pay off mortgages for the sold property) less the tax basis of the property and any gain for which income taxes were paid.

Although the Revenue Procedure is generally effective for taxpayers whose like-kind exchanges fail due to a qualified intermediary default occurring after January 1, 2009, taxpayers in that situation may still use the Revenue Procedure to file an original or amended income tax return for previous open years.

(Revenue Procedure 2010-14, March 8, 2010.)

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this website was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

Tax and financial advice from the Silicon Valley expert.