The Internal Revenue Service has outlined a safe harbor method to report a gain or loss for taxpayers who initiate deferred like-kind exchanges but fail to complete the exchange because a qualified intermediary defaults on its obligation to acquire and transfer the replacement property.
Under Section 1031(a) of the Tax Code, no gain or loss is recognized on an 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 that is to be held either for productive use in a trade or business or for investment
The regulations allow for deferred exchanges of property, in which, pursuant to an exchange agreement, the taxpayer transfers a relinquished property and subsequently receives a replacement property. The taxpayer must identify the replacement property within 45 days of the transfer of the relinquished property, and acquire the replacement property within 180 days of the transfer of the relinquished property, or by the due date of the taxpayers return (including extensions) for the year of the transfer of the relinquished property, if sooner.
A taxpayer is allowed to use a qualified intermediary to facilitate a like-kind exchange. As required by the written exchange agreement entered into with the taxpayer, the QI acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. If a taxpayer transfers relinquished property using a QI, the taxpayers transfer of the relinquished property to the QI and subsequent receipt of replacement property from the QI is treated as an exchange with the QI. However, if a taxpayer actually or constructively receives money in the full amount of the consideration for the relinquished property, the transaction is considered a sale and not a deferred like-kind exchange.
The Internal Revenue Service said it is aware of situations in which taxpayers initiated like-kind exchanges by transferring relinquished property to a QI and were unable to complete these exchanges within the exchange period solely due to the failure of the QI to acquire and transfer replacement property to the taxpayer. In many such cases, the QI enters bankruptcy or receivership, thus preventing the taxpayer from obtaining immediate access to the proceeds of the sale of the relinquished property.
The IRS and the Treasury Department generally hold the view that a taxpayer who in good faith sought to complete the exchange using the QI, but who failed to do so because the QI defaulted on the exchange agreement and became subject to a bankruptcy or receivership proceeding, 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.
If a QI defaults on its obligation to acquire and transfer replacement property to the taxpayer and becomes subject to a bankruptcy or receivership proceeding, the taxpayer generally may not seek to enforce its rights under the exchange agreement with the QI or otherwise access the sale proceeds from the relinquished property outside of the bankruptcy or receivership proceeding while the proceeding is pending.
Consequently, the IRS will treat the taxpayer as not having actual or constructive receipt of the proceeds during that period if the taxpayer reports gain in accordance with Revenue Procedure 2010-14. Accordingly, the taxpayer needs to recognize gain on the disposition of the relinquished property only as required under the safe harbor gross profit ratio method described in Section 4.03 of the revenue procedure. For more information, see Revenue Procedure 2010-14.
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